Financial Management

Unit 1
Meaning of Financial Management
Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.

Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working
capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the
returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital so
that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in
an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt equity
analysis. This will depend upon the proportion of equity capital a company is possessing
and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices likea. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits
like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansionary, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Functions of Financial Manager

Managerial finance functions are functions that require managerial skills in their planning,
execution and control. The managerial finance functions are as follows:
1. Investment Decision
Investing decision is the managerial decision regarding investment in long-term proposals. It
includes the decision concerned with acquisition, modification and replacement of long-term
assets such as plant, machinery, equipment, land and buildings. Long term assets
require huge amount of capital outlay at the beginning but the benefits are derived over
several periods in the future. Because the future benefits are not known with certainty, longterm investment proposals involve risks. The financial manager should estimate the expected
risk and return of the long-term investment and then should evaluate the investment
proposals in terms of both expected returns and risk. The financial manager accepts the
proposal only if the investment maximizes the shareholders wealth.
2. Financing Decision
Financing decision which is also known as capital structure decision, is concerned with
determining the sources of funds and deciding upon the proportionate mix of funds from
different sources. It calls for raising of funds from different sources maintaining appropriate
mix of capital. The sources of long-term funds include equity capital and debt capital. A
particular combination of debt and equity may be more beneficial to the firm than any others.
The financial manager should decide an optimal structure of debt and equity capital.

3. Dividend Decision
Dividend decision is the decision about the allocation of earnings to common shareholders. It
is concerned with deciding the portion of earnings to be allocated to common shareholders.
The net income after paying preference dividends belongs to common shareholders. The
financial manager has three alternatives regarding dividend decision:
* Pay all earnings as dividend
* Retain all earnings for reinvestment
* Pay certain percentage of earning and retain the rest for reinvestment.
The financial manager must choose among the above alternatives. The choice should be
optimum in the sense that it should maximize the shareholders wealth. While taking dividend
decisions, the financial manager should consider the preference of shareholders as well as the
investment opportunities available to the firm.

4. Working Capital Decision

Working capital decisions refers to the commitment of funds to current assets and deciding on
their financing pattern. It refers to the current assets investment and financing decision.
Investment in current assets affects firm's profitability and liquidity. More investment
in current assets enhances liquidity. Liquidity refers to the capacity to meet short-term
obligation of the firm. At the same time more investment in current assets negatively affects
the profitability because current assets earn nothing or they earn much less than their cost of
capital. Similarly, less investment in current assets negatively affects the firm's liquidity and
the firm may lose its profitable opportunities. So, a financial manager should achieve a proper
trade-off between liquidity and profitability which requires maintaining optimal investment
in current assets.

The following explanation will help in understanding each finance function in detail
Investment Decision
One of the most important finance functions is to intelligently allocate capital to long
term assets. This activity is also known as capital budgeting. It is important to allocate
capital in those long term assets so as to get maximum yield in future. Following are the
two aspects of investment decision
a. Evaluation of new investment in terms of profitability
b. Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected
return. Along with uncertainty comes the risk factor which has to be taken into
consideration. This risk factor plays a very significant role in calculating the expected
return of the prospective investment. Therefore while considering investment proposal it
is important to take into consideration both expected return and the risk involved.
Investment decision not only involves allocating capital to long term assets but also
involves decisions of using funds which are obtained by selling those assets which
become less profitable and less productive. It wise decisions to decompose depreciated
assets which are not adding value and utilize those funds in securing other beneficial
assets. An opportunity cost of capital needs to be calculating while dissolving such
assets. The correct cut off rate is calculated by using this opportunity cost of the required
rate of return (RRR)
Financial Decision
Financial decision is yet another important function which a financial manger must
perform. It is important to make wise decisions about when, where and how should a
business acquire funds. Funds can be acquired through many ways and channels. Broadly
4

speaking a correct ratio of an equity and debt has to be maintained. This mix of equity
capital and debt is known as a firms capital structure.
A firm tends to benefit most when the market value of a companys share maximizes this
not only is a sign of growth for the firm but also maximizes shareholders wealth. On the
other hand the use of debt affects the risk and return of a shareholder. It is more risky
though it may increase the return on equity funds.
A sound financial structure is said to be one which aims at maximizing shareholders
return with minimum risk. In such a scenario the market value of the firm will maximize
and hence an optimum capital structure would be achieved. Other than equity and debt
there are several other tools which are used in deciding a firm capital structure.
Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key
function a financial manger performs in case of profitability is to decide whether to
distribute all the profits to the shareholder or retain all the profits or distribute part of the
profits to the shareholder and retain the other half in the business.
Its the financial managers responsibility to decide a optimum dividend policy which
maximizes the market value of the firm. Hence an optimum dividend payout ratio is
calculated. It is a common practice to pay regular dividends in case of profitability
Another way is to issue bonus shares to existing shareholders.
Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firms
profitability, liquidity and risk all are associated with the investment in current assets. In
order to maintain a tradeoff between profitability and liquidity it is important to invest
sufficient funds in current assets. But since current assets do not earn anything for
business therefore a proper calculation must be done before investing in current assets.
Current assets should properly be valued and disposed of from time to time once they
become non profitable. Currents assets must be used in times of liquidity problems and
times of insolvency.

Financial forecasting
A financial forecasting is an estimate of future financial outcomes for
a company or country (for futures and currency markets). Using historical internal accounting
and sales data, in addition to external market and economic indicators, a financial forecast is

an economist's best guess of what will happen to a company in financial terms over a given
time periodwhich is usually one year.
Arguably, the most difficult aspect of preparing a financial forecast is predicting revenue.
Future costs can be estimated by using historical accounting data; variable costs are also a
function of sales.
Unlike a financial plan or a budget a financial forecast doesn't have to be used as a planning
document. Outside analysts can use a financial forecast to estimate a company's success in
the coming year.

Financial Forecasting describes the process by which firms think about and prepare for the
future. The forecasting process provides the means for a firm to express its goals and
priorities and to ensure that they are internally consistent. It also assists the firm in identifying
the asset requirements and needs for external financing.
For example, the principal driver of the forecasting process is generally the sales forecast.
Since most Balance Sheet and Income Statement accounts are related to sales, the
forecasting process can help the firm assess the increase in Current and Fixed Assets which
will be needed to support the forecasted sales level. Similarly, the external financing which
will be needed to pay for the forecasted increase in assets can be determined.
Firms also have goals related to Capital Structure (the mix of debt and equity used to finance
the firms assets), Dividend Policy, and Working Capital Management. Therefore, the
forecasting process allows the firm to determine if its forecasted sales growth rate is
consistent with its desired Capital Structure and Dividend Policy.
The forecasting approach presented in this section is the Percentage of Sales method. It
forecasts the Balance Sheet and Income Statement by assuming that most accounts maintain
a fixed proportion of Sales. This approach, although fairly simple, illustrates many of the
issues related to forecasting and can readily be extended to allow for a more flexible
technique, such as forecasting items on an individual basis.

Financial Planning
Financial Planning is the process of estimating the capital required and determining its
competition. It is the process of framing financial policies in relation to procurement, investment
and administration of funds of an enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:
a. Determining capital requirements- This will depend upon factors like cost of current
and fixed assets, promotional expenses and long- range planning. Capital requirements
have to be looked with both aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e.,
the relative kind and proportion of capital required in the business. This includes decisions
of debt- equity ratio- both short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally
utilized in the best possible manner at least cost in order to get maximum returns on
investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes and budgets
regarding the financial activities of a concern. This ensures effective and adequate financial and
investment policies. The importance can be outlined as1. Adequate funds have to be ensured.
2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of
funds so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in companies
which exercise financial planning.
4. Financial Planning helps in making growth and expansion programmes which helps in longrun survival of the company.
5. Financial Planning reduces uncertainties with regards to changing market trends which can
be faced easily through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth
of the company. This helps in ensuring stability an d profitability in concern.

Steps of Financial Planning

7

There are six steps to the financial planning process:

1.

Establishing and defining the client-planner relationship

2.

Gathering client data including goals

3.

Analyzing and evaluating the clients current financial status

4.

Developing and presenting recommendations and/or alternatives

5.

Implementing the recommendations

6.

Monitoring the recommendations

Financial planning subject areas denotes the basic subject fields covered in the financial
planning process which typically include, but are not limited to:

Financial statement preparation and analysis (including cash flow analysis/planning and
budgeting)

Insurance planning and risk management

Employee benefits planning

Investment planning

Income tax planning

Retirement planning

Estate planning

Estimate Financial Needs for Your Business

1.

Understand how to estimate the

1.1 Identify the main items of expenditure for your

finances needed to fund your

business, such as drawings, own wage, premises,

business

equipment, supplies and, staff

1.2 Estimate the costs of these items to your business
1.3 Identify different ways of financing your business

2.

Understand how to estimate

2.1 Estimate how much money your business will need

income and expenditure for your

to make over a six month period, as a minimum, taking

business

into account own living expenses

2.2 Work out a realistic selling price for the product or
service so that the finances of your business break even
2.3 Decide whether additional funding will be needed to
cover all the costs of your business

3.

Understand how to estimate profit 3.1 Use income and expenditure to calculate projected
and loss for your business

gross and net profit for a minimum six month trading

period
3.2 Set realistic financial targets for your business

Unit 2

Sources of Funds to Raise Long Term Capital

The sources of funds refer to the mediums by which an organization raises its long-term
capital and working capital.
The organization can select any of the sources of funds depending upon the need and
gestation period of the project to be financed.
The explanation of these sources of funds (as shown in Figure-1) is given as follows:
(a) Issue of Shares:
Involve the public issue of equity and preference shares in the stock exchange. Issuing
shares is the most common method of raising long-term capital because there are various
many investors who are ready to invest in the capital market. Therefore, shares are used
to finance projects having long gestation period.
(b) Issue of Debentures:

Involve the collection of funds by issuing debentures in the stock exchange. When an
organization issues debentures, it needs to pay a fixed rate of interest to debenture
holders.
(c) Term Loans:
Refers to the funds that are raised from financial institutions for financing long-term
projects. The rate of interest on term loans is higher than the rate of interest on
debentures.
(d) Fund from Operations:
Refers to the fund raised by the organizations own operations. It is the accumulated
profit of an organization; therefore, can be used to finance various short-term and longterm projects.
(e) Sale of Fixed Assets:
Helps in generating funds by selling fixed assets, such as land, buildings, plants, and
machineries to finance short-term and long-term projects. However, the usage of this
method may hamper the goodwill and creditworthiness of the organization.
(f) Sale of Current Assets:
Involves selling assets, such as bills receivables and stocks. These assets are generally
sold by an organization to meet short-term fund requirements.
(g) Decrease in Working Capital:
Refers to the reduction in the working capital either by decreasing current liabilities or
increasing current assets. The increase in current assets or decrease in current liabilities
provides funds for financing short-term projects.
(h) Receipt of Interest, dividend, and refund of tax:
Helps in financing short-term projects or meeting the working capital needs. This type of
funds does not create any liability, as these are income of the organizations. Capital
budgeting is performed by using various techniques. These techniques help in measuring
the actual cost and returns generated from a project and comparing multiple projects
with respect to their profitability. However, the actual cost and returns of a project cannot
be forecasted without understanding the concept of TVM.

Sources of Short-term Finance

There are a number of sources of short-term finance which are listed
below:
1. Trade credit
10

2. Bank credit
Loans and advances
Cash credit
Overdraft
Discounting of bills
3. Customers advances
4. Instalment credit
5. Loans from co-operatives
1. Trade Credit
Trade credit refers to credit granted to manufactures and traders by the
suppliers of raw material, finished goods, components, etc. Usually
business enterprises buy supplies on a 30 to 90 days credit. This means
that the goods are delivered but payments are not made until the expiry
of period of credit. This type of credit does not make the funds available
in cash but it facilitates purchases without making immediate payment.
This is quite a popular source of finance.
2. Bank Credit
Commercial banks grant short-term finance to business firms which is
known as bank credit. When bank credit is granted, the borrower gets a
right to draw the amount of credit at one time or in instalments as and
when needed. Bank credit may be granted by way of loans, cash credit,
overdraft and discounted bills.
(i) Loans
When a certain amount is advanced by a bank repayable after a
specified period, it is known as bank loan. Such advance is credited
to a separate loan account and the borrower has to pay interest on
11

the whole amount of loan irrespective of the amount of loan

actually drawn. Usually loans are granted against security of assets (or your ass).
(ii) Cash Credit
It is an arrangement whereby banks allow the borrower to withdraw
money upto a specified limit. This limit is known as cash credit
limit. Initially this limit is granted for one year. This limit can be
extended after review for another year. However, if the borrower
still desires to continue the limit, it must be renewed after three
years. Rate of interest varies depending upon the amount of limit.
Banks ask for collateral security for the grant of cash credit. In
this arrangement, the borrower can draw, repay and again draw the
amount within the sanctioned limit. Interest is charged only on the
amount actually withdrawn and not on the amount of entire limit.
(iii) Overdraft
When a bank allows its depositors or account holders to withdraw
money in excess of the balance in his account upto a specified
limit, it is known as overdraft facility. This limit is granted purely
on the basis of credit-worthiness of the borrower. Banks generally
give the limit upto Rs.20,000. In this system, the borrower has to
show a positive balance in his account on the last friday of every
month. Interest is charged only on the overdrawn money. Rate of
interest in case of overdraft is less than the rate charged under
cash credit.
(iv) Discounting of Bill
Banks also advance money by discounting bills of exchange,
promissory notes and hundies. When these documents are presented
12

before the bank for discounting, banks credit the amount to

cutomers account after deducting discount. The amount of discount
is equal to the amount of interest for the period of bill. This part
has been discussed in detail later on in this chapter.
Sources of Short-term Finance :: 15
3. Customers Advances
Sometimes businessmen insist on their customers to make some
advance payment. It is generally asked when the value of order is
quite large or things ordered are very costly. Customers advance
represents a part of the payment towards price on the product (s)
which will be delivered at a later date. Customers generally agree
to make advances when such goods are not easily available in the
market or there is an urgent need of goods. A firm can meet its
short-term requirements with the help of customers advances.
4. Instalment credit
Instalment credit is now-a-days a popular source of finance for
consumer goods like television, refrigerators as well as for
industrial goods. You might be aware of this system. Only a small
amount of money is paid at the time of delivery of such articles.
The balance is paid in a number of instalments. The supplier charges
interest for extending credit. The amount of interest is included
while deciding on the amount of instalment. Another comparable
system is the hire purchase system under which the purchaser
becomes owner of the goods after the payment of last instalment.
Sometimes commercial banks also grant instalment credit if they
have suitable arrangements with the suppliers.
13

5. Loans from Co-operative Banks

Co-operative banks are a good source to procure short-term
finance. Such banks have been established at local, district and
state levels. District Cooperative Banks are the federation of
primary credit societies. The State Cooperative Bank finances and
controls the District Cooperative Banks in the state. They are also
governed by Reserve Bank of India regulations. Some of these
banks like the Vaish Co-operative Bank was initially established as
a co-operative society and later converted into a bank. These banks
grant loans for personal as well as business purposes. Membership
is the primary condition for securing loan. The functions of these
banks are largely comparable to the functions

14

15

Retained earnings refer to the percentage of net earnings not paid out
as dividends, but retained by the company to be reinvested in its core business, or to
pay debt. It is recorded under shareholders' equity on the balance sheet.
The formula calculates retained earnings by adding net income to (or subtracting any
net losses from) beginning retained earnings and subtracting any dividends paid to
shareholders:
Retained Earnings (RE) = Beginning RE + Net Income Dividends

Pros & Cons of Institutional Borrowing

Immediate Infusion of Cash
The main benefit of borrowing money from a financial institution is the ability to
obtain a large amount of money quickly. This money can be used for necessary
purchases and investments, including investments in your own education.
Financial institutions can lend more money than most friends and family members
can.

Interest Rates
Financial institutions attach interest rates to the principal amount borrowed. An
interest rate can either be a positive or a negative. Borrowers with good credit can
attain a loan with a lower interest rate. This, in turn, makes the loan less
expensive in the long run. Borrowers with poor credit scores can likely only attain
a loan at higher interest rates. This can make borrowing money an expensive
decision and possibly unattractive as a financial option. Interest rates also
fluctuate. As such, borrowers should watch interest rates to borrow when rates are
low. A strong credit score and favorable market interest rates produce a favorable
borrowing environment.

Collateral
Collateral is a legal interest, otherwise known as a lien, that a financial institution
places on an asset in case you default on your loan. A common form of this
16

interest is the home mortgage. Collateral removes the risks a financial institution
takes on when lending out large sums of money (a house mortgage or car loan,
for example). Upon defaulting, the financial institution takes control of the asset
and sells it for a profit to cover any losses. This secures the institution against
losses and creates the freedom to lend out larger amounts. Loans backed by
collateral, also known as secured loans, offer lower interest rates but present the
clear danger of losing your property.

Traditional Banks and Credit Unions

Traditional banks and credit unions offer different benefits to borrowers.
Traditional banks offer services to all potential customers. Even though anyone
can potentially use the financial services of traditional banks, these financial
institutions often offer loans at high interest rates. Credit unions, on the other
hand, are open to specific groups of people, usually people who live in a specific
geographical location or those who belong to certain professions. These financial
institutions often offer their members lower interest rates, but, unlike a bank, not
everyone can become a customer.

Lawsuits
Failure to pay your loan can result in a lawsuit being filed against you. This can
result in wage garnishment and a negative mark on your record. This is one of the
worst possible outcomes, but it's why all borrowers must remain wary and
conservative when taking out a loan from a financial institution.

Public deposits

Public deposits are an important source of financing the medium-term and long-term requirements of a company.
The term 'public deposit' implies any money received by a company through the deposits or loans collected from
the public. The public includes the general public, employees and shareholders of the company but excludes the
money received in the form of shares and debentures. In India, this method of raising finance has gained a lot of
importance because of the several advantages relating to public deposits:

It is an easier method of mobilising funds, especially during periods of credit squeeze.

17

The administrative cost of deposits for the company is lower than that involved in the issue of shares and
debentures. The procedure of inviting public deposits is also simpler and involve lesser formalities.

The rate of interest payable by the company on public deposits is lower than the interest on loans from
banks and other financial institutions. Such an interest is a tax deductible expense.

It helps the company to borrow funds from a larger segment of public and thus reduces the dependence of
the company upon financial institutions.

It also enables the company to create contact with a large number of investors.

It ensures the availability of funds for a longer duration and provides flexibility to the financial structure of
the company. There is no risk of over-capitalisation and the deposits can be repaid when they are not
required.

There is no dilution of shareholders' control as the depositors have no voting rights and cannot interfere
with the internal management of the company.

But this mode of financing through public deposits has its own limitations:

As the public deposits are more likely to be affected by the uncertain conditions in the economy, the
depositors response may vary accordingly. They may also tend to withdraw their deposits if the company is
not performing well.

Public deposits with the companies may cause a diversion of resources into non-priority and undesirable
areas.

Professional investors may not like to invest in such deposits as there is no or less chance for capital
appreciation.

As public deposits are unsecured, the depositors may have to bear the risk of loss of money in the event of
failure of the company.

Their widespread use restricts the growth of a healthy capital market. They also tend to distort the interest rate
pattern of the economy and may result in the dearth of sound industrial securities

Lease Financing: Types, Advantages and Disadvantages

Lease financing is one of the important sources of medium- and long-term financing where the
owner of an asset gives another person, the right to use that asset against periodical payments.
The owner of the asset is known as lessor and the user is called lessee.
The periodical payment made by the lessee to the lessor is known as lease rental. Under lease
financing, lessee is given the right to use the asset but the ownership lies with the lessor and at
the end of the lease contract, the asset is returned to the lessor or an option is given to the lessee
either to purchase the asset or to renew the lease agreement.

Different Types of Lease:

18

Depending upon the transfer of risk and rewards to the lessee, the period of lease and
the number of parties to the transaction, lease financing can be classified into two
categories. Finance lease and operating lease.
i. Finance Lease:
It is the lease where the lessor transfers substantially all the risks and rewards of
ownership of assets to the lessee for lease rentals. In other words, it puts the lessee in
the same condition as he/she would have been if he/she had purchased the asset.
Finance lease has two phases: The first one is called primary period. This is noncancellable period and in this period, the lessor recovers his total investment through
lease rental. The primary period may last for indefinite period of time. The lease rental for
the secondary period is much smaller than that of primary period.
ii. Features of Finance Lease:
From the above discussion, following features can be derived for finance lease:
1. A finance lease is a device that gives the lessee a right to use an asset.
2. The lease rental charged by the lessor during the primary period of lease is sufficient
to recover his/her investment.
3. The lease rental for the secondary period is much smaller. This is often known as
peppercorn rental.
4. Lessee is responsible for the maintenance of asset.
5. No asset-based risk and rewards is taken by lessor.
6. Such type of lease is non-cancellable; the lessors investment is assured.
iii. Operating Lease:
Lease other than finance lease is called operating lease. Here risks and rewards incidental
to the ownership of asset are not transferred by the lessor to the lessee. The term of such
lease is much less than the economic life of the asset and thus the total investment of
the lessor is not recovered through lease rental during the primary period of lease. In
case of operating lease, the lessor usually provides advice to the lessee for repair,
maintenance and technical knowhow of the leased asset and that is why this type of
lease is also known as service lease.
iv. Features of Operating Lease:
Operating lease has following features:
19

1. The lease term is much lower than the economic life of the asset.
2. The lessee has the right to terminate the lease by giving a short notice and no penalty
is charged for that.
3. The lessor provides the technical knowhow of the leased asset to the lessee.
4. Risks and rewards incidental to the ownership of asset are borne by the lessor.
5. Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment.
Advantages and Disadvantages of Lease Financing:
At present leasing activity shows an increasing trend. Leasing appears to be a costeffective alternative for using an asset. However, it has certain advantages as well as
disadvantages.
i. Advantages:
Lease financing has following advantages
a. To Lessor:
The advantages of lease financing from the point of view of lessor are summarized below
Assured Regular Income:
Lessor gets lease rental by leasing an asset during the period of lease which is an assured
and regular income.
Preservation of Ownership:
In case of finance lease, the lessor transfers all the risk and rewards incidental to
ownership to the lessee without the transfer of ownership of asset hence the ownership
lies with the lessor.
Benefit of Tax:
As ownership lies with the lessor, tax benefit is enjoyed by the lessor by way of
depreciation in respect of leased asset.
High Profitability:

20

The business of leasing is highly profitable since the rate of return based on lease rental,
is much higher than the interest payable on financing the asset.
High Potentiality of Growth:
The demand for leasing is steadily increasing because it is one of the cost efficient forms
of financing. Economic growth can be maintained even during the period of depression.
Thus, the growth potentiality of leasing is much higher as compared to other forms of
business.
Recovery of Investment:
In case of finance lease, the lessor can recover the total investment through lease
rentals.
b. To Lessee:
The advantages of lease financing from the point of view of lessee are discussed below:
Use of Capital Goods:
A business will not have to spend a lot of money for acquiring an asset but it can use an
asset by paying small monthly or yearly rentals.

Tax Benefits:
A company is able to enjoy the tax advantage on lease payments as lease payments can
be deducted as a business expense.
Cheaper:
Leasing is a source of financing which is cheaper than almost all other sources of
financing.
Technical Assistance:
Lessee gets some sort of technical support from the lessor in respect of leased asset.
Inflation Friendly:

21

Leasing is inflation friendly, the lessee has to pay fixed amount of rentals each year even
if the cost of the asset goes up.
Ownership:
After the expiry of primary period, lessor offers the lessee to purchase the assets by
paying a very small sum of money.
ii. Disadvantages:
Lease financing suffers from the following disadvantages
a. To Lessor:
Lessor suffers from certain limitations which are discussed below:
Unprofitable in Case of Inflation:
Lessor gets fixed amount of lease rental every year and they cannot increase this even if
the cost of asset goes up.
Double Taxation:
Sales tax may be charged twice:
First at the time of purchase of asset and second at the time of leasing the asset.
Greater Chance of Damage of Asset:
As ownership is not transferred, the lessee uses the asset carelessly and there is a great
chance that asset cannot be useable after the expiry of primary period of lease.
b. To Lessee:
The disadvantages of lease financing from lessees point of view are given
below:
Compulsion:
Finance lease is non-cancellable and even if a company does not want to use the asset,
lessee is required to pay the lease rentals.
Ownership:

22

The lessee will not become the owner of the asset at the end of lease agreement unless
he decides to purchase it.
Costly:
Lease financing is more costly than other sources of financing because lessee has to pay
lease rental as well as expenses incidental to the ownership of the asset.
Understatement of Asset:
As lessee is not the owner of the asset, such an asset cannot be shown in the balance
sheet which leads to understatement of lessees asset.

What is 'Venture Capital'

Venture capital is financing that investors provide to startup companies and small
businesses that are believed to have long-term growth potential. For startups without
access to capital markets, venture capital is an essential source of money. Risk is
typically high for investors, but the downside for the startup is that these venture
capitalists usually get a say in company decisions.

Venture capital (VC) is a type of private equity,[1] a form of financing that is provided
to small, early-stage, emerging firms that are deemed to have high growth potential, or which
have demonstrated high growth (in terms of number of employees, annual revenue, or both).
Venture capital funds invest in these early-stage companies in exchange for equityan
ownership stakein the companies they invest in. The start-ups are usually based on
aninnovative technology or business model and they are usually from the high
technology industries, such as Information technology (IT),social media or biotechnology. The
typical venture capital investment occurs after an initial "seed funding" round. The first round
of institutional venture capital to fund growth is called theSeries A round. Venture capitalists
provide this financing in the interest of generating a return through an eventual "exit" event,
such as the company selling shares to the public for the first time in anInitial public
offering (IPO) or doing a merger and acquisition (also known as a "trade sale") of the
company.

Commercial paper, in the global financial market, is an unsecured promissory note with a
fixed maturity of no more than 270 days.

23

Commercial paper is a money-market security issued (sold) by large corporations to

obtainfunds to meet short-term debt obligations (for example, payroll), and is backed only by
an issuing bank or company promise to pay the face amount on the maturity date specified
on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a
recognized credit rating agency will be able to sell their commercial paper at a reasonable
price. Commercial paper is usually sold at a discount from face value, and generally carries
lower interest repayment rates than bonds due to the shorter maturities of commercial paper.
Typically, the longer the maturity on a note, the higher the interest rate the issuing institution
pays. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.
Commercial paper though a short-term obligation is issued as part of a continuous rolling
program, which is either a number of years long (as in Europe), or open-ended (as in the
U.S.).[1]

Factoring is a financial transaction and a type of debtor finance in which a business sells its
accounts receivable (i.e., invoices) to a third party (called a factor) at a discount.[1][2][3][4] A
business will sometimes factor its receivable assets to meet its present and immediate cash
needs.[5][6] Forfaiting is a factoring arrangement used in international trade
finance by exporters who wish to sell their receivables to a forfaiter.[7] Factoring is commonly
referred to as accounts receivable factoring, invoice factoring, and sometimes accounts
receivable financing. Accounts receivable financing is a term more accurately used to
describe a form of asset based lending against accounts receivable.[8] The Commercial
Finance Association is the leading trade association of the asset-based lending and factoring
industries.

Cash management refers to a broad area of finance involving the collection, handling, and
usage of cash. It involves assessing market liquidity, cash flow, and investments.[2][3]
In banking, cash management, or treasury management, is a marketing term for certain
services related to cash flowoffered primarily to larger business customers. It may be used to
describe all bank accounts (such as checking accounts) provided to businesses of a certain
size, but it is more often used to describe specific services such as cash concentration, zero
balance accounting, and automated clearing house facilities. Sometimes, private banking
customers are given cash management services.
Financial instruments involved in cash management include money market funds, treasury
bills, and certificates of deposit.[4]

24

What is 'Cash Management'

Cash management is the corporate process of collecting and managing cash, as well as using it for
(short-term) investing. It is a key component of ensuring a company's financial stability
and solvency. Corporate treasurers or business managers are frequently responsible for overall
cash management and the related responsibilities to remain solvent.

OBJECTIVES OF CASH MANAGEMENT

To maintain optimum cash balance.
To nkeep the optimum cash balance requirements at minimum level by prompt collection &
late disbursement etc

Inventory management
Inventory management is a very important function that determines the health of the
supply chain as well as the impacts the financial health of the balance sheet. Every
organization constantly strives to maintain optimum inventory to be able to meet its requirements
and avoid over or under inventory that can impact the financial figures.
Inventory is always dynamic. Inventory management requires constant and careful evaluation of
external and internal factors and control through planning and review. Most of the organizations
have a separate department or job function called inventory planners who continuously monitor,
control and review inventory and interface with production, procurement and finance departments.

Defining Inventory
Inventory is an idle stock of physical goods that contain economic value, and are held in various
forms by an organization in its custody awaiting packing, processing, transformation, use or sale in
a future point of time.
Any organization which is into production, trading, sale and service of a product will necessarily
hold stock of various physical resources to aid in future consumption and sale. While inventory is a
necessary evil of any such business, it may be noted that the organizations hold inventories for
various reasons, which include speculative purposes, functional purposes, physical necessities etc.
From the above definition the following points stand out with reference to inventory:

All organizations engaged in production or sale of products hold inventory in one form or
other.

Inventory can be in complete state or incomplete state.

Inventory is held to facilitate future consumption, sale or further processing/value addition.

25

All inventoried resources have economic value and can be considered as assets of the
organization.

Different Types of Inventory

Inventory of materials occurs at various stages and departments of an organization. A
manufacturing organization holds inventory of raw materials and consumables required for
production. It also holds inventory of semi-finished goods at various stages in the plant with
various departments. Finished goods inventory is held at plant, FG Stores, distribution centers etc.
Further both raw materials and finished goods those that are in transit at various locations also
form a part of inventory depending upon who owns the inventory at the particular juncture.
Finished goods inventory is held by the organization at various stocking points or with dealers and
stockiest until it reaches the market and end customers.
Besides Raw materials and finished goods, organizations also hold inventories of spare parts to
service the products. Defective products, defective parts and scrap also forms a part of inventory
as long as these items are inventoried in the books of the company and have economic value.

Types of Inventory by Function

INPUT

PROCESS

OUTPUT

Raw Materials

Work In Process

Finished Goods

Consumables required
for processing. Eg :
Fuel, Stationary, Bolts &
Nuts etc. required in
manufacturing

Semi Finished
Production in various
stages, lying with
various departments
like Production, WIP
Storesi, QC, Final
Assembly, Paint Shop,
Packing, Outbound
Store etc.

Finished Goods at
Distribution Centers
through out Supply
Chain

Maintenance
Items/Consumables

Production Waste and

Scrap

Finished Goods in transit

Packing Materials

Rejections and
Defectives

Finished Goods with

Stockiest and Dealers

Local purchased Items

required for production

Spare Parts Stocks &

Bought Out items

26

Defectives, Rejects and

Sales Returns
Repaired Stock and Parts
Sales Promotion &
Sample Stocks

27

iCapital

rationing

Capital rationing is a common practice in most of the companies as they have more profitable projects
available for investment as compared to the capital available. In theory, there is no place for capital
rationing as companies should invest in all the profitable projects. However, a majority of companies follow
capital rationing as a way to isolate and pick up the best projects under the existing capital restrictions.
Definition of Capital Rationing
Capital rationing is the process of putting restrictions on the projects that can be undertaken by the company or
the capital that can be invested by the company. This aims in choosing only the most profitable investments for
the capital investment decision. This can be accomplished by putting restrictive limits on the budget or selecting
a higher cost of capital as thehurdle rate for all the projects under consideration. Capital rationing can be
either hard or soft.
Assumptions of Capital Rationing
The primary assumption of capital rationing is that there are restrictions on capital expenditures either by way of
all internal financing or investment budget restrictions. Firms do not have unlimited funds available to invest in
all the projects. It also assumes that capital rationing can come out with an optimal return on investment for the
company whether by normal trial and error process or by implementing mathematical techniques like integer,
linear or goal programming.
Advantages of Capital Rationing
Capital rationing is a very prevalent situation in companies. There are few advantages of practicing capital
rationing:
o

o
o

o
o

Budget: The first and an important advantage are that capital rationing introduces a
sense of strict budgeting of corporate resources of a company. Whenever there is an
injunction of capital in the form of more borrowings or stock issuance capital, the
resources are properly handled and invested in profitable projects.
No Wastage: Capital rationing prevents wastage of resources by not investing in each
and every new project available for investment.
Fewer Projects: Capital rationing ensures that less number of projects are selected by
imposing capital restrictions. This helps in keeping the number of active projects to a
minimum and thus manage them well.
Higher Returns: Through capital rationing, companies invest only in projects where the
expected return is high, thus eliminating projects with lower returns on capital.
More Stability: As the company is not investing in every project, the finances are not
over-extended. This helps in having adequate finances for tough times and ensures more
stability and increase in the stock price of the company.

Disadvantages of Capital Rationing

Capital rationing comes with its own set of disadvantages as well. Let us describe the problems that rationing
can lead to:
o

Efficient Capital Markets: Under efficient capital markets theory, all the projects that
add to companys value and increase shareholders wealth should be invested in.

o
o

However, by following capital rationing and investing in only certain projects, this theory
is violated.
The cost of Capital: In addition to limits on budget, capital rationing also places
selective criteria on the cost of capital of shortlisted projects. However, in order to follow
this restriction, a firm has to be very accurate in calculating the cost of capital. Any
miscalculation could result in selecting a less profitable project.
Un-Maximising Value: Capital rationing does not allow for maximising the maximum
value creation as all profitable projects are not accepted and thus, the NPV is not
maximized.
Small Projects: Capital rationing may lead to the selection of small projects rather than
larger scale investments.
Intermediate Cash Flows: Capital rationing does not add intermediate cash flows from
a project while evaluating the projects. It bases its decision only the final returns from the
project. Intermediate cash flows should be considered in keeping thetime value of
money in mind.

Conclusion
Though capital rationing has few disadvantages, it is still followed widely in selecting investment projects. A
company should decide on following capital rationing after studying the implications in details.