FINANCIAL MANAGEMENT NOTES

BY- YASHWANT PRATAP SINGH

Important topics of Financial Management-2

Semester - 3 (acc to NEP)

UNIT-1

Chapter - 1 Important topics

Business finance (Basic theory)

Functions of CFO

Financial Management (Basic theory)

Profit maximization

v/s

Wealth maximization

Chapter - 2 Important topics

Time value of money (Basic theory)

Chapter - 3 Important topics

Capital budgeting ( Basic theory)

Numericals : NPV method & IRR method

●●●●●●●●●●●●●●●●●●●●●●●●

UNIT-2

Chapter - 4 Important topics

Capitalization (Basic theory)

Difference b/w Over-capitalization and Under- capitalization

Numericals :

• Cost of preference capital

• Cost of equity capital

• Cost of debt/ debenture capital

Chapter - 5 Important topics

Capital structure (Basic theory)

NI & MM approach

Numerical on types of leverage

●●●●●●●●●●●●●●●●●●●●●●●●

UNIT-3

Chapter - 6 Important topics

Dividend definition & types

Dividend policy & its types

Dividend models :

1. Walter's model

2. Gordon's model

3. MM (Modgilani & Miller) model [MOST IMP]

4. Traditional/ Residual model

●●●●●●●●●●●●●●●●●●●●●●●●

UNIT-4

Chapter - 7 Important topics

Working capital ( Basic theory)

Types of working capital (eg - net working capital / gross woking capital / variable working
capital / permanent working capital)

Chapter - 8 Important topics

Cash management ( Basic theory)

Models :

• Baumol's model

• Miller-Orr model

Inventory management ( Basic theory)

●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●
Introduction to Business Finance

Finance is the backbone of any business. Finance is generally the art and science of managing
all the monetary resources of a business and it is extremely crucial for the survival of any
business enterprise.

Finance helps in the procurement of various resources as well as ensures the smooth flow of
business operations.

Basically, "the term finance is considered as the management of money or financial

resources of a business enterprise."

Business Finance is also known as finance function or Corporation function.

It deals with assessment, procurement and management of funds.

Nature of Business Finance

• Includes all category of funds (owners fund or borrowed fund)

• Required in all type of businesses

• Dependent on size and nature of operations(complex in MNCs whereas simpler in small

businesses)

• Requirement of finance varies from time to time

• It involves estimation

• It has continuous requirement

Significance of Business Finance

Business Finance is majorly important:

1. For acquiring fixed assets

2. For purchasing raw materials or other goods

3. For hiring labour/workforce

4. For paying operating expenses

5. For adopting latest technology

6. For meeting the contingencies

Objectives of Business Finance

1. Analysing the financial requirement

2. Proper utilisation of funds

3. Increasing Profitability
 4. Maximizing value of firm

Scope of Business Finance

• Estimating financial requirements

• Deciding the capital structure

• Selecting a source of finance

• Selecting the pattern of investment

• Cash management

• Proper uses of surplus

• Implementing financial control

The board of directors is the ultimate body responsible for managing the finance function. The
finance function is majorly managed by the Chief financial offices (CFO) who takes all the
important financial decisions of a company.

Functions of CFO as a treasurer

Cash management function

Credit Management function

Financial planning function

Securities flotation function

Functions of CFO as a controller

To maintain and examine the books of account, financial statements, Internal auditing, etc
which helps in formulating the best financial strategies.

●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

Concept of Financial Management

To understand the concept of Financial Management let's understand both of these terms
separately.

"Financial" denotes the process of identifying, obtaining and allocating sources of money for
any business and on the other hand "Management" is the process of planning, organising,
coordinating and controlling various resources for attaining organisational goals.

Thus, "the management concerned with the planning, organising, coordinating and
controlling of financial resources is known as financial management."
Approaches to financial management

1. Traditional school of thought/approach

Under this school of thought, the scope of financial management was only limited to the
procurement of funds and the finance manager was supposed to provide funds as and when
required by the organisation.

Limitations

• It looked at financial management from the outsider point of view and did not
considered financial management as the core function.

• It only focuses on major Investments and overlooks the regular issues of financial
management.

• Ignores fund allocation.

• Overlooks working capital financing.

2. Modern school of thought/approach

Model School of approach viewed financial management in a broader sense and derived its 4
major function as investing decision, financing decision, dividend policy decision and liquidity
decision.

It caters all the limitations of traditional school of thought for financial management.

●○●○●○●○●○●○●○●○●○●

Functions of financial management

1. Investing decision

It is concerned with the identification of assets that require investment. It can be long term
assets, short term assets/current assets.

Investment decision can be broadly classified into two main categories:

1. Capital budgeting decisions which determine the long term financial health of a firm.

2. Working capital decisions which are short term in nature and determine the management of
current assets to remain profitable and liquidifiable.

2. Financing decision

This function of Financial Management is concerned with determining the financing mix or
capital structure of a firm.

Capital structure is sometimes defined as the ratio of debt and equity capital of a firm.

3. Dividend policy decision

This function of Financial Management is concerned with deciding that whether to retain the
profit or to distribute the profit among the stakeholders.

4. Liquidity decision

It is closely related to working capital decision. This decision is concerned with proper
administration of current assets which assures that a firm is completing its commitment on
regular basis.

○●○●○●○●○●○●○●○●○●○●○

Significance of financial management

Financial Management is significant because of its following roles:

• Finance is itself a controling function

• It aids to managerial decisions

• Results in wealth maximization

• Financial Management is an analytical tool

• It is administrative in nature

• Finance function is centralised

Functional areas of financial management

"Finance being the blood of any business, financial management becomes the core of any
business."

It works in harmony with the other management departments and functional areas of a
business such as Economics, accounting Mathematics, production management, marketing as
well as Human Resource Departments.

Financial Management and all the above mentioned functional areas are completely, directly or
indirectly dependent on each other for smoothly running a business.

°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°°

Objectives of financial management

In a broader sense there are two main objectives of financial management.

1. Profit maximization

Profit maximization is the traditional and narrow approach as it considers that maximization of
profit is the sole objective of any business

Features of profit maximization

• Related to maximization of earnings per share.

 • Increasing profitability is the foremost concern.

• Profit is the benchmark of business survival and well-being.

• Maximization of profit minimises risk and uncertainty.

Limitations of profit maximization

• Ambiguity

As the term profit is an unlear and confusing concept because there are endless types of profit,
for example, profit after tax, profit before tax, short term profit, long term profit, etc.

• Timing of benefits

Profit maximization does not considers the time value of money (you will read about it in detail
in Chapter 2).

• Quality of benefits

Ignores the qualitative aspect of benefits and returns.

• Impacts the social welfare

• Results in increased cut throat competition

2.Wealth maximization

Wealth maximization is also known as value maximization or net present worth

maximization.

Wealth maximization is free from all the limitations of profit maximization as it considers timing
benefits as well as qualitative aspects of returns.

Wealth maximization is concerned with the holistic development of any business.

Features of wealth maximization

• Simple to understand

• Important for investment decisions

• Considers time value of money and risk factors

• Eliminates limitation of profit maximization

Limitations

• Incorrect assumptions

• Speculations

"Wealth maximization is superior to profit maximization"

●Due to uncertainty of future, it is not possible to determine the profit in advance, so

maximizing unknown profit is not a feasible at all.

●In fact, the definition of profit is vague and there is no clear meaning to it.
●Predictions of future returns is also not possible to be made by the decision-maker & hence,
no efforts are made to maximize it.

●The objective of profit maximization is narrowly defined and it does not considers the time
value of money.

Whereas

Wealth maximization says that the organisation should make efforts towards "satisfying" in
place of "maximizing" and hence, it is superior to profit maximization in these aspects.

Finance manager

"The person solely responsible for carrying out the finance functions of accompany who is a part
of top management team and extremely efficient in solving complicated fund management
issues is known as finance manager."

The person also acts are the financial advisor to the top management.

Role of a financial manager

Raising funds of a company Finance by estimating short term and long term requirements.

Taking maximum benefits from leverages(financial and operating Assets of a company).

Making International Financial decisions and always updating himself/herself with the latest
developments taking place in the international market.

Making sound investment decisions

Efficient risk management

Risks can never be avoided in a business but identification and efficient management of risk is
the responsibility of a financial manager.

Time Value of Money (TVM)

The central Idea behind the "Theory of time value of money" is the fact that the money received
today is worth more than the same amount of money at any future date.

To understand it clearly, let's say that it simply means that "one rupee today is more than the
same one rupee tomorrow".

When this concept is preferred for present money against the future money, then it is termed
as time preference for money.

The difference between the value of money at present date and the value of same money at
future date is termed as "time value of money"

Need/Reasons for time value of money

1. Risk and uncertainty

Cash outflow is always certain but cash inflow is always doubted and risky and hence, time
value of money is preferred.

2. Preference for consumption

Goods and services consumed by the consumer are usually thier urgent and present
requirements. Hence, they prefer to have money now to consume now.

3. Investment opportunities

A rupee invested today will give higher level of value in the future by considering time value of
money.

4. Inflationary economy

The main reason behind considering the concept of time value of money is the inflationary
behaviour of economy, as the purchasing power of same amount of money is decreasing year by
year.

○○○○○○○○○○○○○○○○○○○○○○○○○○○

Concept of simple interest and compound interest

Simple interest is the interest paid or computed only on the original amount (principal amt) of a
loan or investment.

Compound interest is the interest calculated on the initial principle amount as well as
accumulated interest on that amount. This is why it is also known as "interest on interest"

NOTE : The concept of compound interest makes a loan or deposit grow at a faster rate than
that of simple interest.

●●●●●●●●●●●●●●●●●●●●●●●●●●●

Basic valuation techniques

Basically there are two valuation techniques for finding the time value of money.

1. Compounding/ Future value techniques

2. Discounting/ Present value techniques

Compounding future value techniques

These techniques abide by the concept of compounding. This is similar to the concept of
compound interest.

1. Future value of a single cash flow is calculated by the formula:

FV=PV(1+r)^n

FV is Future value

PV is Present value

R is rate of interest
n is no. of periods or no. of years or time gap

2. Future value of uneven cash flow

It can be easily derived by adding all the single cash flows in the uneven cash flow stream.

3. Future value of annuity / series of equal cash flows

Many imvestments provide fixed amount of regular cash flows at regular intervals and such
regular clash flows are known as an annuity.

Formula to calculate them is:

Where

FVAn is future value of annuity with time period of n

A is constant periodic flow

r is rate of interest

n is time period of annuity

●Growing annuity

A finite series of regular cash flows growing at fixed rate every year is known as growing annuity.

Formula to calculate it :

WHERE,

FV(A) is the value of annuity

A is the value of individual payment

i is interest rate

n is number of period

g is growth rate
●●●●●●●●●●●●●●●●●●●●●●●●●●●●

Discounting present value technique

It is defined as the process of determining the present value of a payment or stream of

payments which is likely to be the used in the future time.

It is just the opposite of compounding technique.

RELATION OF PV to OTHER FACTORS:

》》PV is positively related to FV which means in order to get higher future value, higher
investment should be made today (which means higher present value).

》》PV is inversely related to interest rate(r) which means higher the interest rate, lower will
be the present value requirement because money will grow quickly and vice versa.

》》PV is inversely related to time period(n) because longer the time period lower the present
value will be required as money will grow more in longer time period and vice versa.

1. Formula for finding the present value of single cash flow is :

2. Present value of uneven cash flow streams can be calculated by adding up all the different
cash flows in the streams together as we do in the calculation of finding future value of an even
cash flows.

3. Present value of annuity / series of equal cash flows is calculated by the following formula :

●Present value of growing annuity is calculated by the following formula:

☆Where everything has same meaning as the formula of future value growing annuity Only CF1
here means cash flow at the end of period 1.

4. Present value of perpetuity

Annuity with no fixed time period is known as perpetuity.

The formula to calculate present value of perpetuity:

Growing perpetutity is a type of annuity which increases the payment gradually over an
indefinite period of time.

The formula to derive growing perpetuity is:

●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

Concept of annuity due

Phenomenon in which an annuity whose payment is to be made immediately rather than at the
end of the time period is termed as annuity due.

Doubling period

Investors are generally interested in knowing the amount of time taken for doubling the value of
their investment.

In regards to this, two rules are used to derive the doubling period of any investment.

1. Rule 72

It is the simple way to determine the time period for a investment to double its value (when the
rate of interest is fixed).

By dividing 72 by the annual rate of return, we get a rough estimate of the amount of time
required to double an investment.

2. Rule 69

It is the general rule to estimate the doubling period (when compound interest is used) on any
investment.

It is done by dividing 69 by the rate of return.

●●●●●●●●●●●●●●●●●●●●●●●●●●

Applications of the concept of TVM

Concept of TVM is practically used for :

1. Finding out the implicit rate of interest.

2. Finding out the number of periods.

3. Requirement of sinking funds (Sinking funds are defined as the fund created by any
business entity by setting aside a fixed amount of money for a particular time period
which can help the business in the repayment of long term loans or can be helpful in
paying for unforseen capital expenditure.)

4. Capital recovery(The concept of TVM can be used to find out the annual amount
required to be paid for recovering the invested capital in a business.)

●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

Loan amortization

This concept states that there are some borrowers who are willing to repay the loan amount but
after a definite time period.

For example, if a borrower has taken loan of 10000 and will start paying the interest on it after 6
months, then the lender will calculate the time value of those 6 months and then he will
implement the interest on the loan taken and the borrower will have to pay the total interest of
those 6 months.

To understand it clearly, it simply says that if the borrower is willing to repay loan after some
amount of time, then the lender will calculate the time value of money from the day of lending
and will then apply the interest on the loan amount.

●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

Capital budgeting

Investment decision pertaining to long term assets for the purpose of generating revenue for the
business entity is termed as capital budgeting.

Moreover, capital expenditure differs from revenue expenditure in the sense that the benefits
from capital expenditure are necessarily generated after a long gestation period which is
generally beyond one year.

"Capital budgeting is a long term planning for making and financing capital expenditures of a
company or a business."

Components of capital budgeting

 • Cash outflows (Investment to be made)

• Cash Inflows (Return on the investment made)

• Cut off rate (The minimum level of return expected on an investment)

• Ranking the proposal (In case of many investment options, ranking of the best option
becomes necessary in order to invest in the best proposal)

• Risk and uncertainty

• Non-monetary view (For example, goodwill or reputation of the company in market)

Objectives of capital budgeting

●Maintaining firm's competitiveness

Modernization of plants and replacement of obsolete plant and machinery are necessary for a
company in order to survive and grow in the market, which is done through capital budgeting.

●Planning for future needs of funds

●Coordinating

Capital budgeting is done in order to achieve the maximum output through the available
resources of a business.

●Cost control

Capital budgeting involves the comparison of budgeted expenditure and actual expenditure
which helps in controlling the unnecessary expenditures.

●Capital budgeting improvises company's effectiveness

Process of capital budgeting investment

1. Screening and selection

2. Capital budget proposal

3. Budgeting approval and authorization

4. Project tracking

5. Post-completion audit

Factors influencing capital budgeting

• Availability of funds

• Future earnings

• Compliance with statutory provisions

• Risks involved

• Urgency

• Research and development

 • Obsolescence

• Competitors activities

• Integral factors (For example, Employee welfare schemes, safety measures,etc)

Importance of capital budgeting

1. Long term effects

Decision which are taken through capital budgeting are generally irreversible. The outcome of a
wrong capital decision can cause heavy losses but on the very same hand an effective capital
decision is always profitable in the long run for a company.

2. Risk and uncertainty

Capital budgeting decisions are based on 2 most important components which is investment
and return. Uncertainty and risk are directly proportional to the period of project. Hence, a
proper and calculated capital budgetinv decision helps to deal with risk and uncertainty in an
effective manner.

3. Larger funds

While investing in large products huge amount of money is required and hence capital
budgeting is given the most importance before taking the investment decision.

4. Corporate image

An effective or ineffective capital budgeting decision affects the image of a company in the
market.

Difficulties in capital budgeting

• Future uncertainty

• Time element

• Measurement problems (inaccurate estimates)

Moving on to our next heading

Cash flows

Cash flow is a dynamic process in which the money moves into or outto of a business.

Thus, significance of cash flow lies in the time element.

In simple language, cash flow refers to incoming and outgoing of the cash in any business.

A proper cash management is highly recommended in order to lead a profitable business.

Cash flows are of to type which is:

○Cash outflow (investment made) and

○Cash inflow (return on investment made)

Note:

Cash flows as profit

Cash flows of a company are completely different from profits of a company.

As cash flows means the incoming or outgoing of any kind of cash in a business but profit
means the net income of a business which is calculated after deducting interests, taxes,
depreciation and many other non cash items.

Components of cash flow

1. Initial investment

Which can be defined as, net taxes+net working capital

2. Operating cash inflows

The cash inflow across from the operations of a project in which a business has invested is
known as operating cash inflows.

3. Terminal cash inflows

During the process of liquidation, at the end of project's economic life, the accrued cash inflow
is known as terminal cash inflows.

Techniques of capital budgeting

1. Traditional/Non-discounting Cash Flow techniques or methods

• Payback period

• Accounting Rate of Return(ARR)

2. Time adjusted/Discounted Cash Flow techniques or methods

• Net Present Value(NPV)

• Internal Rate of Return(IRR)

• Profitibality index(PI)

Payback period method

Number of years required to make the cumulative cash outflows equal to cumulative cash
inflows for a project is its payback period.

In simple terms, payback period in investment recovery time duration.

Payback period = Intial outflow of the project / Annual cash inflow

Decision Rule
If computer payback period is less than standard target period, then project is favourable and
vice versa.

Advantages

• No expertize required

• Liquidity indication

• Indicates risk with time factor

Disadvantages

• Overlooks cash inflows

• Time value of money is not considered

• Overlooks slavage value

• Only focuses on initial investment's recovery

Accounting Rate of Return(ARR) method

ARR is also known as Return on Investment (ROI).

ARR=Avg profit(after tax)/Avg investment

Advantages

• Easy calculation

• Considers entire cashflows

Disadvantages

• Overlooks time value of money

• Use of only accounting data

• Problem of comparability

Net Present Value (NPV) method

This method anticipated discounting (by applying suitable discount factors for each year) of the
cash inflows(likely to accrue in future year) to get the present value.

The discounting rate in this method is also known as required return, cost of capital or
opportunity cost.

Decision rule

NPV>0 Proposal can be accepted

NPV<0 Proposal can be rejected

NPV=0 Breakeven

Advantages

• Time value of money is recognised

 • Sound method of project appraisal

Disadvantages

• Difficult to understand

• May not be completely accurate

Internal Rate of Return (IRR)

IRR is defined as discount rate which equates cumulative present value of inflows to outflows a
project.

It is also known as :

Yeild on investement

Marginal efficiency of capital

Marginal productivity of capital

Rate of returb

Time adjusted rate of return

Decision rule

IRR>K Proposal can be accepted

IRR<K Proposal can be rejected

IRR=K Break even

Advantages

• Consideration of time value

• Easy to understand

• Indicates profitability or loss in a project

Disadvantages

• Difficult calculation

• Confusion in multiple rates

Profitability Index(PI) method

Also known as Benefit-cost ratio or Cost-benefit ratio.

This method basically assesses the profitability related to an investment proposal helpful in the
purpose of comparison.

PI = Present value of cash inflows/Present value of cash outflows

Decision rule

PI>1 Proposal acception

PI<1 Proposal rejection

PI=0 Break even

Advantages

• Conforms with objective of shareholders' wealth maximization

• Considers time value of money

Disadvantages

• Indept of long term projections needed

• Determination of IR is not easy in it.

Capitalization

Capital means the total amount of money employed for a business.

Capitalization is basically the expansion of the word "capital" which can be defined as "the total
amount of fund attained by a firm from different long term sources."

Need of capitalization

At the time of :

• Promotion & incorporation stage

• Expansion stage

• Amalgamation & absorption stage

• Capital reorganisation

Reasons for change in capitalization

• Making financial plan balanced (The change in capitalization may be required if current
capital structure is not balanced)

• For simplifying the capital structure

• For meeting investors requirement

• For funding current liabilities

• For covering the deficit

• For capitalizing the retained earning (Firm may issue bonus shares)

• For utilization of retained earnings

Theories of capitalization

1. Cost theory

According to this theory, the value of firm is determined by the sum total of the value of its fixed
asserts, its working capital, promotional expenses and setup cost.
2. Earnings theory

According to this theory the value of company depends upon its earning capacity. This process
entails determination of probable sales and related cost.

Types of capitalization

1. Over Capitalization

When a firm's earning are not enough to provide a fair rate of return on the capital employed,
then it indicates that the firm may be overcapitalized.

This happens in the case when the firm is not able to pay dividends on its shares or service the
interest on its debentures.

Symptoms of overcapitalization

1. Larger investment

2. Reflection of wrong picture

3. No full utilization

Causes of overcapitalization

1. Availability of excess capital

2. Purchase of assets at higher price

3. High promotional expenses

4. Borrowings at higher late

5. Buying assets during boom phase

6. High taxation rate

Consequences/ Effects of overcapitalization

Effects on the company

• Loss of goodwill

• Low creditworthiness

• Obstacles in obtaining further capital

• Lower efficiency

• Inflated profit

Effects on shareholders

• Reduction in dividend

• Lower share value

Effects on society

• Loss to consumers
 • Loss to workers

• Under utilization or miss-utilization of resources

• Gambling in shares

Remedies for over capitalization

1. Efficient management to reduce the excessive expenditures

2. Redemption of preference share (As these shares generally carry the highest interest
rate so management can redeem them by using retained earnings.)

3. Reduction of funded debt (Debentures and public deposits have high interest rates.
Hence, repaying them in an accumulated amount can reduce the problem of
overcapitalization.)

4. Reorganization of equity share can also reduce the face value of equity shares.

●●●●●●●●●●●●●●●●●●●●●●

2. Under capitalization

This is the opposite situation to over capitalization.

Under capitalization may show efficient management of resources as well as it can lead to high
amount of dividend and earnings per share.

In simple language, this situation usually indicates the positive impact on the market value of
the shares.

Symptoms of under capitalization

1. Sudden rise in earnings

2. Pessimistic forecast

3. Low cost

Causes of under capitalization

1. Under estimation of capital requirements

2. Under estimation of future earnings

3. Promotion during deflation

4. Narrow dividend policies(company may adopt conservative policy for paying dividends)

5. Desire of control (in the urge of holding the control of a company, the members may
decide to raise funds only by using debt capital instead of raising equity and hence after
some time the company will automatically become under capitalized)

Consequences/ Effects of under capitalization

1. Manipulation of shares

2. Marketability of shares
 3. Industrial unrest (the workers may ask for higher wages, the staff may ask for increment
in salary, etc)

4. Increase in government control (due to increasing profit rates in undercapital company)

5. Unsatisfied consumers (the news of a company making higher levels of profit may make
the customers think that the goods are over priced)

6. Higher competition (higher profit margins attracts new businesses in the same industry)

7. Overtrading and undercutting of the products

8. Can lead to overcapitalization

Remedies for under capitalization

1. Fresh issue of shares

2. Issue of a bonus shares

3. Increasing the far value of share (This can reduce the earnings per share)

4. Stock split (This method increases the numbers of share of a firm which consequently
decreases the value of each share)

●●●●●●●●●●●●●●●●●●●●●●●●●●●●

Concept of cost of capital/opportunity cost

The cost of capital is the minimum rate of return which enables a company to make such an
amount of profit on its investment so as to ensure that the market value of the company's equity
shares either increases or remains at the same level.

This is in conformity with any company's goal of "wealth maximization for its shareholders".

Wealth maximization for shareholders of a company is a concept in which the company focuses
upon the overall development of the wealth of its shareholders by providing them their expected
rate of return on their investment.

In simple terms, cost of capital is the minimum required rate of earning or the cut off rate of
capital expenditure or it is the minimum rate of return expected by the investors of a business
on the project.

"Opportunity cost of capital is the lost value of an investment due to the investment made
in some other project."

For an investor, it is the choice offered to him to invest in one project over another.

Opportunity cost of the investment is also known as minimum required rate of return OR cost of
capital OR discount rate OR Interest rate

Characteristics of cost of capital

●It is not necessarily a cash cost

●It indicates the minimum rate of return

●It considers the risk factor

Classification of cost

1. Future cost versus historical cost

Future costs are the basis on which financial decisions are taken and they are only used as
projections whereas historical costs are like guiding tools for future forecasting.

2. Specific cost versus composite cost

Specific cost is the cost of individual source of capital whereas composite cost also known as
overall cost is the cost of capital of all the sources taken together.

3. Average cost versus marginal cost

The average of costs of capital taken together is average cost whereas the change in the total
cost that arises when the quantity produced at increment by unit is marginal cost.

4. Implicit cost versus explicit cost

Instant cash payments are associated with explicit cost, for example, rent OR payment of wage,
salary, etc these are also known as out of pocket cost whereas no cash payments are
associated with implicit cost, for example, loss of interest rate OR wages forgone by owner of
company, etc. This is also known as economic cost or opportunity cost.

Factors affecting cost of capital

1. General economic conditions

These are factors external to the company's operational boundaries and beyond its control. The
general conditions prevailing in an economy are largely responsible for the demand and supply
of the capital.

2. Market conditions

The prevailing market conditions at a particular point of time are responsible for the level of risk
and a rate of return associated with a financial decision.

3. Company's operations and financing decisions

These decision affects the cost of capital & these decisions involve business risk as well as
financial risk.

NOTE:

Business risk are the outcome of the company's investment decision.

Financial risks are an increase in fluctuation in the return to the equity shareholders.

4. Amount of financing

The cost of capital OR the cost of funds is directly proportional to the required amount of funds
or capital.

Importance of cost of capital

1. It is important in taking capital budgeting decisions.

2. It is important while making capital structure decisions.

3. It helps in the evaluation of profitability of any project.

4. It is helpful while taking other decisions such as dividend distribution, working capital
requirement, etc.

Problems in determination of cost of capital

1. Influence of the mode and quantum of financing

It is a very controversial issue which has been a matter of debate between the traditional
theorist and modern theorist.

2. Calculation of cost of equity capital

Calculation poses a number of hurdles even when theoretical definition of cost of capital is very
easy but its calculation is always difficult.

3. Computation of cost of retained earnings and debentures funds is quite difficult to

understand.

●●●●●●●●●●●●●●●●●●●●●●●●●●●

Capital structure

Capital structure or capital framework of a company comprises of long term capital funds
raised by it from different sources for the conduct of its business activities.

Various component of capital structure are raised from time to time to meet the demands and
needs of a company which generally consist of :

• Equity shares

• Preference shares

• Debt funds (bonds and debenture funds)

• Borrowed or long term funds

• Retained earnings

In simple words, capital structure is the composition of a firm's funds from different
financing sources.
Capital framework may have a two fold impact on a company, which means the capital
structure of a company affects the:

Cost of capital and

The valuation of a company

Optimal capital structure

Capital structure of a company may be considered as optimal or balanced one, if its financial
plan has an appropriate debt equity mix which results in enhancing the company's value to the
maximum level.

Maximization of the market value of a company's shares needs to be the objective of an optimal
capital planning which is possible when each source of capital has the same marginal cost, the
above concept is however, more theoretical in nature.

Optimal capital structure formed on the basis of preassumptions may go wrong as the capital
markets are not perfect due to lack of information and exposure to risk.

But optimal capital structure should exhibit following essential characteristics in order to
be termed as an optimal capital structure:

Profitability

Capital structure needs to conform with the objective of earning profit by minimizing the cost of
capital and maximizing earnings per share.

Solvency

Capital structure of a company should be designed in such a way that it remains solvent.

Flexibility

Due to market forces, the management should be in a position to bring about various changes in
the capital structure. Hence, it should be flexible.

Conservative

Capital structure of a company needs to be conservative as far as possible at the level of its
debt components which simply means that the debt funds should be within the manageable
limit of a company.

Control

Capital structure should be framed in such a way that there is the least chance of outsiders
taking control over the company.

Simplicity

Simple components like equity or preference shares especially during the formative stage of a
company should be given the utmost preference.
Liquidity

The liquidity position of a company is the determinant of its capability to meet the liability
arising out of the debt capital. Hence, the capital structure of a company should always be in a
manner that it can be liquidified at the time of need.

Components of capital structure

A) Owner's capital

1. Equity shares

These are the elementary source of raising funds.These are the most costly source of raising
funds. Equity shareholders are the true owners of company and they have the highest level of
business risk.

The balance of net profit after payments to all other claimants is distributed among equity
shareholders.

2. Preference capital

Preference shareholders are given priority in dividend payout over ordinary shareholders.

Dividend should be paid at a fixed rate to preference shareholders.

Return of capital should be repaid at the time of winding up of the company to preference
shareholders.

3. Retained earnings

A part of net profit earned during the year is set aside for investment purposes and this is known
as retained earning.

The company uses this earning for the growth and expansion of the business

B) Borrowed capital

1. Debentures

When funds are raised through this mode, company enters into a contract with the subscribers
of the ventures.

It had fixed interest rate of payment and it is the repable on a fixed maturity date.

2. Term loans

These are usually given by financial institutes.

The lenders are commercial banks and other financial institutions and they charge a fixed rate
of interest for a period of 3 years or more.

Determinants of capital structure

1. Financial leverage or trading on equity

It can be defined as the optimal use of borrowed capital and owner's capital to increase the
potential return on investment.
Company with more debt than equity is considered to be highly leveraged.

2. Operating leverage

It is the ratio of Company's fixed costs to variable costs.

It is in the interest of the company to ensure that both the leverages are not at the high level at
same time, either financial leverage should be lower than operating leverage or vice versa.

3. EBIT/EPS analysis

Earning Before Interest & Tax and Earning Per Share are two crucial indicators of Company's
performance. A financial strategy with forecast of higher EPS is considered as the best.

4. Cost of capital

Overall cost of capital plays a vital role which revolves around the debt & equity ratio(DER).

5. Growth & stability of sales

Stable sales and increasing growth rate are the key performance indicators for having more
borrowed fund as the company can pay off its liabilities through stablized sales.

6. Tax exposure of a company

Debt payment is tax deductible under Income Tax Act and hence, any company financing a
project with higher debt fund can save lot of tax.

7. Flexibility

It is the outcome of a capital structure with low level of debt component

8. Control

Excessive dependence on either "equity" or "debt" components may prove harmful to the
company in long run.

9. Marketability

10. Nature and size of industry

11. Industry standards

12. Growth rate

13. Market conditions

14. Management style (Risk averse/conservative & aggressive)

15. Floatation cost(cost incurred while raising funds)

Importance of capital structure

1. To reduce the overall risk of a company

Capital structure can act a risk management tool for a company if designed carefully and
strategically.

2. To make adjustments according to businesse environment

There is a need to have appropriate strategy for future capital mix to meet the future needs.

3. Idea generation for new source of fund.

NOTE:

Planning of capital structure involves four basic and most important analysis, viz,

EBIT/EPS Analysis

Cost of capital analysis

Cash flows analysis

Leverage analysis

All three analysis have already been taught in other chapters so for now we will focus on the
fourth analysis, viz,

●●●●●●●●●●●●●●●●●●●●●

Leverage Analysis

Leverage refers to the use of fixed cost instruments to maximize the return potential for the
shareholders.

In simple words, leverage can be defined as each and every variable that has an impact on the
returns available to the shareholders .

Types of leverage

1. Financial leverage

Also known as trading on equity. It is concerned with the financial structure of a firm.

It focuses on optimal use of financial resources in order to maximize the EBIT responding to
higher EPS.

2. Operating leverage

Operating leverage is related to the cost structure of a firm. It uses fixed costs incurred by a
firm to maximize the returns. A cost is considered to be fixed when it remains the same even
with the change in the output.

Formula for Operating leverage is:

And

3. Combined/Composite Leverage

Composite leverage is the amalgamation of operating leverage and financial everage.

Operating leverage determines the percentage change in operating profit in response to

percentage change in sales. It defines the degree of operating risk. On the other hand, financial
leverage is concerned with effect of percentage change in operating profit or EBIT on EPS.

In this way, the leverage defines the degree of financial risk undertaken by the firm.

Composite leverage is used to describe the interrelationship between the sales revenue and
taxable income.

●●●●●●●●●●●●●●●●●●●●
Meaning and Definition of Dividend

The term dividend denotes that part of company's balance of profit (after the execution of its
'Retained Earning'), which is available for equal distribution amongst the shareholders
(investors) of the company. Dividends are a form of incentive to the shareholders for having
invested in the company's shares. This is the return out of the profit made by a company during
a year, for its shareholders (beneficiaries).

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

shareholders out of profits or reserves available for this purpose".

Forms/Types of Dividend

A. On the basis of Types of shares

1. Equity dividend

Dividends which are distributed among equity shareholders.

Rate of interest in not fixed.

2. Preference dividend

Dividends which are distributed among preference shareholders. The of dividend is fixed.

B. On the basis of mode of payment

1. Cash dividend

During the Annual General Meeting, the recommendation of BoD is approved by the
shareholders and the process of "declaration of cash dividends" is finished. A declared cash
dividend is part of shareholder's equity (and not a liability of the company), as decision in the
matter may be reversed. On Treasury Stocks, no cash payments are made.

2. Bonus Share/Stock Dividend

Sometimes, when the profits made by a company are substantial, it may decide to retain a part
thereof by capitalising and retaining it in the business perpetually by issuing stock dividends
(additional or bonus stocks/shares in lieu of cash)

3. Scrip Dividend

In a situation, where in a company is:

a) Suffering from a temporary liquidity crunch, and

b) Has an adequate level of retained earnings.

It may decide to issue Scrip Dividends' in lieu of 'Cash Dividends'.

'Scrip Dividends' may be issued either as 'Promissory Notes' (which may be discounted before
its 'due date') or 'Ordinary Shares'.

4. Bond Dividends

'Bond Dividends' may be defined as 'dividend distribution that is paid to shareholders in the
form of a bond or debenture (debt instruments) instead of cash'.

It has fixed rate of interest for long duration.

Issue of 'Bond Dividends' is opted by a company under the same situation as that of issue of
'Scrip Dividends', and have the same impact.

5. Property Dividend

'Property Dividend' is an alternative to 'Cash Dividend', 'Scrip Dividend' or 'Bond Dividend'.

It is rather an uncommon payout structure, in which there is transfer of non-monetary asset

between a company and its shareholders on a non-reciprocal basis.

6. Composite Dividend

When dividend payment involves two or more types mentioned in the foregoing types, it is
known as 'Composite Dividend'.

C. On the Basis of Time of Payment

1. Interim Dividend

Dividend is normally declared in the Annual General Meeting (AGM) of a company after the
finalisation of the balance sheet at the end of a financial year.

However, at times the dividend is declared and paid before the finalisation of the balance sheet
or before AGM of a company.

Such dividend is rightly termed as 'Interim Dividend' and is paid when the Management/Board of
the company has reasons to believe that the company has already earned enough profits.

2. Regular dividend

The dividend declared during AGM in normal course of business.

3. Special dividend

In the year of huge profits, company may consider distribution of special dividend.

It is a one time affair.

•••••••••••••••••••••••••••

Scope of dividend function

1. Legal position
There will be legal restrictions by different countries on the total dividend amount being paid.

2. Profitability

Is order to pay dividends, it is important to have some kind of profits. Greater profitability,
greater amount of dividend and vice versa.

3. Infation

The opeartional capacity of any organization can be depleted if dividends are paid depending on
past cost profits when inflation rate is high.

4. Growth

As the majority of the revenue is reserved for the financial development, very low dividends are
paid by the fast developing organisations.

5. Control

There will be no change in the control or ownership due to utilisation of internally generated
revenue. Especially the family governed organisations will be more benefited from it.

6. Liquidity

In order to pay the dividend, it is important to have adequate liquid funds.

●●●●●●●●●●●●●●●●●●●●●●●●●

Meaning & definition of Dividend policy

According to Weston and Brigham, "Dividend policy determines the division of earnings
between payments to shareholders and retained earnings".

The 'Dividend Policy' of a company needs to be framed by its management in such a way that
the net earnings are split into 'Retained Earnings' and 'Dividends' in an appropriate manner.

This framed policy should also meet both the objectives of:

1) Business growth, and

2) Maximisation of wealth for its shareholders.

The decision of breaking the 'Net Profit' (post-tax) into two parts, viz.:

1) Retaining in the business for the growth of the company, and

2) Distributing to shareholders as 'Dividend',

It is a crucial one, having long-term impact on the future prospects of the company.

Nature of dividend policy

1. Close relationship with retained earnings

 2. Impacts the future financial decisions

3. Impacts the share

4. Directly impacts market price of share, liquidity position, growth rate, etc.

5. Optimizes dividend structure

Why Firms Pay Dividends

Shareholders of the company are entitled to receive the dividend as profit on the capital
contributed by them. The proportions of earnings for dividend and money retained in the
company are decided by the board of directors of the company.

Execution of dividend payout

• Lack of enough growth opportunities & future plans

• Consistency I regular Cash flows for new instruments

• Investors find dividend paying companies more attractive for investment

Based on the dividend payouts, the investors can make following estimations:

i) The company is financially sound, or

ii) It is capable to provide stable returns, or

iii) The company's management is confident about its future earnings.

Thus, their positive opinions about the dividend payment will increase the demand for
company's shares as more demand for company's shares will automatically raise the prices of
shares.

Essentials of Sound Dividend Policy

Dividend policy decisions are strategic and long-term in nature. Their purpose is to achieve
shareholder's wealth maximization. Following are the main characteristics of a good dividend
policy:

• Distribution of dividend in cash

• Initial lower dividend

• Gradual increase in dividend

• Stability

• Dividend out of earned profits

Types/classification of dividend policy

1) Regular Dividend Policy:

A company having a steady stream of income may prefer this category of 'Dividend Policy'. It
means payment of dividends on a regular basis, even if the rate of dividend is low. In other
words, the focus is on the regularity of dividend payout rather than on it rate.

It's suits investors, who are:

• Retired person

• Person belonging to low income level

2) Stable dividend policy

This category of dividend policy ensures regular payment of fixed percentage out of a company's
annual income to the shareholders.

It has three sub categories:

• Constant dividend per share(reserve fund is created)

• Constant payout ratio (fixed % is given)

• Stable plus extra dividend (extra dividend in the year of higher profit)

3) Irregular dividend policy

When a company does not pay regular dividends to its shareholders because of certain
reasons.

4) No dividend policy

Sometimes a company may like to keep its entire net profit as retained earnings for the purpose
of business growth and expansion.

Determinants of dividend policy

Legal bounding

Dividend policy should be compliant with various statutory provisions under companies act
1956.

Size of earnings

Investment opportunities and shareholders preference

Company should maintain a balance between shareholder's expectation and utilization of

routine earnings for investment

Liquidity position

As dividend payout to shareholders involves cash outflow. Hence, it is important while

formulating dividend policy to make provisions for liquidity status prevailing in a company.

Company's intention towards control

State of capital market and access to it

Contractual restrictions
When a company borrows funds from external sources certain restrictive clause may be
imposed by the lender

Profitability and stability of earnings

A company's investment in high yielding instruments would fetch huge profit for the company
and ice versa.

Inflation

Every year due to inflation, cost of replacing fixed assets increases hence, the fund accumulate
as a depreciation fund becomes insufficient for replacing assets.

Thus, while formulating dividend policy this factor should be kept in mind.

Relevance/Importance of dividend decision

• An optimal dividend policy can maintain a balance between the business growth and
maximization of shareholders wealth.

• It is a decisive force in shaping the market value of a company.

• Rate of dividend payout symbolizes a company's competence to do business effectively

and generate revenue.

• Decision regarding dividend payment may impact a company's external financing plans
in an indirect manner.

• Market value of share price is impacted in a negative manner if the rate of dividend
distributed by a company is low.

In simple words, dividend policy of a company holds a very important role which is capable of
influencing the financial health, fund management, liquidity status and growth of a company.

Issues with dividend decisions

1. Information signaling

The management cannot disclose any information of the company to investors. Due to this, a
communication gap arises between the management and shareholders which can be even
positive or negative in consequences.

2. Clientele effect

Investors have different types of demand and the clientele effect refers to the preference of
investors of the company.

According to the presence of clientele effect, it suggests that the firm will get investors
according to their demand & the firm cannot change its regular dividend policy.

3. Cost of capital

It helps to decide whether the distribution of capital is to be done or not.

4. Objective realization
The dividend policy formulated by a firm should follow the objectives of shareholders' wealth
maximization

Dividend models

Maximization of a company's value is closely linked in direct proportion to the maximization of

it's shareholder's wealth.

The theory of relevance is supported by professor Walter and professor Gordon and the
theory of irrelevance is propounded Modigliani and Miller.

1.A) Walter's Model

Professor Walter proposed a model which maintains that a dividend policy of a company is
applicable in ascertaining its networth.

According to this model dividend received by the shareholders of a company are

reinvested by them onwards to have higher rate of return.

From the company perspective, the cost of dividend paid to the shareholders is considered as
opportunity cost or the cost of capital of the company and dividends which are not being paid to
the shareholders could have been used at as capital by the company.

In other scenario, a company decides not to pay dividends to its shareholders and instead
invest the amount of dividends in some remunerative avenues used to earn a better rate of
return.

Assumptions of Walter's model

• Internal Financing

• Constant return and cost of capital

• Cent per cent payout Or retention

• Constant EPS and D

• Infinte time of business survival

Criticism of Walter's model

• It is more hypothetical in nature and less

• practical.

• It considers no external financing, constant return as well as constant opportunity cost

or cost of capital.

1.B) Gordon's model

This model is postulated by Myron gordon and John Lintner independently and is also referred to
as "bird in hand theory".
This theory is made from the phrase "a bird in the hand is worth two in the bush" where a bird in
the hand is used for 'dividend' and Bush is used for 'capital gains'.

This theory says that investor prefers to have fixed a dividend payout compared to getting
capital gains from the investment in stock.

Assumptions of Gordon's model

• All equity company

• No external financing

• Constant rate of return and cost of capital

• No taxes

Criticism of Gordon's model

Gordon's model has similar assumptions as Walter's model and hence, both of the models are
criticized for the same reason.

2.A) Modigliani nd Miller hypothesis/model

Under the MM model, a view was held for the investors that the dividend and capital gain are
nothing but return on their investment.

The value of company therefore, depends upon its earning which is the outcome of it's :

i) Investment policy and

ii) Overall performance of the industry

The dividend policy of a company has got nothing to do with its valuation.

Assumptions of MM model

• Perfect capital market

• (Which means:

• Investors are reasonable and logical

• There is transparency as well as no flotation cost involved)

• No taxes

• Fixed investment policy

• Risk is not involved

Criticism of MM model

• It does not consider tax differentials which is unrealistic.

• It does not consider flotation cost, as well as,

• It restricts investors from diversifying their portfolios.

 • It does not consider risk factor.

2.B) Traditional/Residual model

This approach is founded by Graham and Dodd.

This theory is relevant to determine the market value of share.

According to the traditional approach, out of net profit enough cash is set aside as retained
earnings which is used for investment in profitable projects.

The residual of net profit of a company is available for distribution among the share holders.

Criticism of residual model

Although there is no practical evidence to support this model but it is obviously convincing and
a logical model because most of the companies prefer to fulfill their investment and growth
strategies before paying the dividends to their shareholders.

UNIT-4
Working Capital Management?

Working capital management is defined as the relationship between a company's short-

term assets and commitments. It tries to ensure that a company's day-to-day operational
expenses can be met while simultaneously investing its resources in the most profitable way
possible. Management of working capital is mainly about making sure that a business has
enough cash flow to pay its short-term debts and cover its short-term running costs. The current
assets minus the current bills of a business make up its working capital. Anything that can be
easily turned into cash within a year is considered a current asset. These are the company's
assets that can be quickly sold. Cash, accounts due, inventory, and short-term investments are
all examples of current assets. Current liabilities are debts that are due within the next 12
months. Some examples are accruals for operational expenses and current parts of payments
on long-term debt.

• Managing a company's working capital means keeping an eye on its assets and debts to
make sure it has enough cash flow to pay its short-term debts and short-term operating
expenses.

• Taking care of cash, inventory, accounts receivable, and accounts payable are the main
parts of managing working capital.

• Managing working capital means keeping an eye on several ratios, such as the working
capital ratio, the collection ratio, and the inventory ratio.

• By making good use of a company's resources, working capital management can help it
control its cash flow and make more money.

• Strategies for managing working capital might not work because of changes in the
market, or they might give up long-term triumphs for immediate benefits.
 Objectives of Working Capital Management
• Working capital management is all about making sure that a company can meet
its short-term financial responsibilities, keeping operations running smoothly, and
increasing the value of shares. These are the main goals of managing working
capital,
• 1. Liquidity Management: One is liquidity management, which means making sure
the company has enough cash on hand to pay its short-term debts as they come
due. To do this, you need to have enough cash on hand and assets that can be
quickly turned into cash to cover your present debts.
• 2. Optimal Utilisation of Resources: Try to find a balance between keeping
enough working cash on hand and not having too many assets that aren't being
used. The goal of this purpose is to make the best use of money by avoiding the
needless holding costs that come with having too much inventory or accounts
receivable.
• 3. Risk Management: Reduce the risks that come with working capital, like credit
risk in accounts payable and inventory going out of date. Strategies for finding,
evaluating, and lowering risks that could affect cash are part of good working
capital management.
• 4. Maximizing Profitability: As long as liquidity is maintained, working capital
management tries to maximise profitability by keeping the cost of hanging onto
extra working capital as low as possible. This includes managing inventory well,
negotiating good credit terms, and finding the best ways to collect on accounts
outstanding.
• 5. Effective Cash Flow Management: Make sure you manage cash flows well so
that you have a steady flow of cash coming in and going out. This means making
accurate predictions about how much cash you will need, collecting receivables
quickly, and managing payables wisely.
• Factors that Affect Working Capital Needs
• There are many internal and external factors that affect how much working cash a
business needs. Understanding these things is important for managing working
capital well. These important things can change how much working cash you
need,
• 1. Sales Growth: When sales grow quickly, companies often need to spend more
on inventory, accounts receivable, and other running assets, which means they
need more working capital.
• 2. Seasonality: Business with seasonal demand need different amounts of
working cash at different times of the year. During busy times, you might need
more supplies and accounts receivable to keep up with customer demand.
• 3. Industry Characteristics: The amount of working capital needed by different
businesses is different. For instance, companies that make things might need to
spend more on inventory and raw materials, while companies that provide
services might not need as much inventory.
• 4. Terms with Suppliers and Customers: The credit terms you agree to with
suppliers and customers have an effect on your operating capital. Longer payment
 terms with providers can lower cash outflows right away, while shorter terms with
customers can speed up cash collections.
• 5. Production Cycle: The time it takes to turn raw materials into finished goods
and then sell those goods can change how much operating capital is needed.
When the output cycle is longer, more inventory is usually needed.
• 6. Credit Policies: Accounts outstanding are affected by the credit policies a
business sets and the terms of credit it offers to customers. Tougher credit rules
might make it easier to get cash faster, but they might also lower the number of
sales.
•
•

• Types of Working Capital

• To put it simply, working capital is the difference between what you owe and
what you own right now. However, there are various kinds of operating capital,
and each may be important for a business to fully understand its short-term
needs.
• 1. Permanent Working Capital: A company's permanent working capital is the
sum of money it will always need to run its business without stopping. This is the
bare minimum of short-term resources that are needed to keep things running.
• 2. Regular Working Capital: Normal working capital is a part of stable working
capital. Being needed for day-to-day business, this part of permanent working
capital is the "most important" part of permanent working capital.
• 3. Reserve Working Capital: The other part of fixed working capital is reserve
working capital. Businesses might need extra working cash on hand in case of
emergencies, changes in the seasons, or events they can't plan for.
• 4. Fluctuating Working Capital: Businesses might only want to know what their
flexible working capital is. As an example, companies may choose to pay for
goods even though the cost changes over time. That being said, the business may
have to pay a regular fee for insurance that it can't refuse. When working capital
changes, it only looks at the changeable debts that the company has full control
over.
• 5. Gross Working Capital: A company's gross working capital is equal to the sum
of its present assets minus its short-term debts.
• 6. Net Working Capital: The difference between your current assets and current
debts is your nett working capital.
• Components of Working Capital Management
• When it comes to managing working capital, some balance sheet accounts are of
greater significance than others. When looking at working capital, it's common to
compare all current assets to current liabilities. However, there are some accounts
that are more important to keep an eye on.
• 1. Cash: Cash flow and cash needs are the most important parts of managing
working capital. This means keeping an eye on the company's cash flow by
estimating how much it will need, planning how it will spend and earn, and
making sure that the company has sufficient cash to pay its bills. Every account
 should be looked at because cash is always a present asset. But businesses
should be aware of payments that are limited or have time limits.
• 2. Receivables: Companies need to be aware of their receives in order to handle
their capital. In the short run, while they wait for credit sales to be completed, this
is very important. This includes overseeing the company's credit policies, keeping
an eye on how much customers pay, and making recovery methods better. It
doesn't matter if a company makes a sale if it can't get paid for it.
• 3. Accounts Payable: Companies can use payables as a tool to better handle their
working capital because they often have more control over this area. A business
may not be able to control some parts of its working capital management, like
selling goods or collecting debts. However, it usually has control over how it pays
its suppliers, the terms of its credit, and when it spends cash.
• 4. Inventory: When companies handle their working capital, they first look at their
inventory because it may be the riskiest part of the process. When a company
wants to turn its goods into cash, it has to go to the market and rely on what
customers want. If this can't be done on time, the company might have to keep
short-term resources that can't be used right away. The company may also be
able to quickly sell the stock, but only if the prices are slashed by a lot.

Approaches of Financing of Current Assets

Current assets of enterprises may be financed either by short-term sources or
long-term sources or by combination of both. The main sources constituting long-
term financing are shares, debentures, and debts form banks and financial
institutions.
1. Matching Approach
As the name itself suggests, a financing instrument would offset the current asset
under consideration, bearing financing instrument bearing approximately same
maturity. In simple words, under this approach a match is established between the
expected lives of current asset to be financed with the source of fund raised to
finance the current assets. For this, reason a firm would select long-term financing
to finance or permanent current assets to finance temporary or variable current
assets. Thus, a ten-year loan may be raised for financing machinery bearing
expected life of ten years. Similarly, one-month stock can be financed by means of
one-month bank loan. This is also termed as hedging approach.
2. Conservative Approach
Conservative approach takes an edge over and above matching approach, as it is
practically not possible to plan an exact match in all cases. A firm is said to be
following conservative approach when it depends more on long-term financial
sources for meeting its financial needs. Under this financing policy, the fixed
assets, permanent current assets and even a part of temporary current assets is
provided with long-term sources of finance and this make it less risky nature.
Another advantage of following this approach is that in the absence of temporary
current assets, a firm can invest surplus funds into marketable securities and store
liquidity.
3. Aggressive Approach
As against conservative approach, a firm is said to be following aggressive
financing policy when depends relatively more on short-term sources than
warranted by the matching plan. Under this approach the firm finance not only its
temporary current assets but also a part of permanent current assets with short-
term sources of finance.In nutshell, it may be concluded that for financing of
current assets, a firm should decide upon two important constraints; firstly, the
type of financing policy to be selected (whether short-term or long term and
secondly, the relative proportion of modes of financing. This decision is totally
based on trade-off between risk and return. As short-term financing is less costly
but risky, long-term financing is less risky but costly.