Financial Management Level of knowledge : Basic
Aim :To assess whether students have acquired basic knowledge about what is financial management, what are the various tools of financial management and methods of financial management f
Detailed contents :
1. Meaning, Importance and objectives of financial management and functions of Finance Manager
2. Finance planning and forecasting cash budgets
3. Operating and financial leverage, cost volume profit analysis
4. Management of working capital - cash management, receivables management, Inventory management and financing of working capital
5. Sources of long term and short term finance – Term borrowings, commercial papers, Equity Shares, Preference shares, debentures etc.
6. Cost of Capital and capital structure theories – cost of different sources of finance
7. Dividend policies
8. Capital budgeting – Basics of capital budgeting and various techniques of capital budgeting
Index
Chapter 1 : Financial Management – an overview
Topic Page no.
1.1 Introduction 5
1.2 Meaning of Financial Management 5
1.3 Importance of Financial Management 7
1.4 Objectives of Financial Management 8
1.5 Functions of finance manager 9
1.6 Financial management and organisational structure 11
1.7 Financial management in India 12
1.8 Self examination questions 14
Chapter 2 : Finance planning and forecasting
Topic Page no.
2.1 Introduction 16
2.2 What is financial planning 16
2.3 Need and Importance of Financial planning 17 2.4 Factors to be considered in a financial plans 17 2.5 Essential characteristics of financial plan 19
2.6 Budgets 20
2.7 Solved problems 20
2.8 Self examination questions 29
Chapter 3 : Operating and financial leverage, cost volume profit analysis
Topic Page no.
3.1 Introduction 33
3.2 Types of leverages 33
3.3 Solved problems on leverages 36
3.4 Cost volume profit analysis 41
3.5 Solved problems on break-even point 43
3.6 Self examination questions 45
Chapter 4 : Management of working capital
Topic Page no.
4.1 Introduction 47
4.2 Meaning of the term working capital 47
4.3 Importance of adequate working capital 48
4.4 How to determine optimum working capital 49
4.5 Working capital cycle 49
4.7 Estimation of working capital requirements 55 4.8 Solved problems on working capital estimation 58 4.9 Factors affecting the working capital requirements 66
4.10 Management of Working capital 67
4.11 Cash Management 67
4.12 Debtors management 71
4.13 Inventories management 73
4.14 Working capital financing in India 75
4.15 Self examination questions 75
Chapter 5 : Sources of long term and short term finances
Topic Page no.
5.1 Introduction 84
5.2 Types of Requirement of funds 84
5.3 Various sources of finance 85
5.4 Long term sources of finance 86
5.5 Short term sources of finance 91
5.6 Modes of charges against a loan 93
5.7 Self examination questions 95
Chapter 6 : Cost of capital and capital structure theories
Topic Page no.
6.1 Introduction 97
6.2 Considerations in Capital structure planning 97 6.3 Determination of cost of various sources of capital 99
6.4 Weighted average cost of capital 106
6.5 Theories of cost of capital 108
6.6 Self examination questions 111
Chapter 7 : Dividend policies
Topic Page no.
7.1 Introduction 115
7.2 Walter model 116
7.3 Gordon model 118
7.4 Irrelevance approach 120
Chapter 8 : Capital Budgeting
Topic Page no.
8.1 Introduction 127
8.2 What is capital budgeting ? 127
8.3 Methods and techniques of capital budgeting 128
8.4 Solved problems 147
8.5 Self examination questions 175
Chapter 9 : assorted questions 182
Students should note that this module is not meant to be an exclusive study material and students are required to refer to other recommended books. Questions in examination may not be necessarily from this material. Though every effort has been made to avoid errors or omissions in this module, there may be errors. Any mistake, error or discrepancy noticed noted may be brought to our notice which shall be taken care of in the next edition .It is notified that the author is not responsible for damage or loss to any one, of any kind, in any manner, therefrom. No part of this study material may be reproduced or copied in any form or by any means (including photocopying), without the written permission of the author.
1 Financial Management – an overview
1.1 Introduction
Management of funds is one of the most important functions of any organisation, be it a profit oriented organisation or social organisation like CRY. In this Chapter, we shall try to understand the basic concepts of financial management i.e. management of money matters.
In our day-to-day life also we face many finance related problems which we try to solve on our own judgement or with the help of friends and relatives examples of such problems can be –
1. Mr A is willing to buy a car but is not sure from which bank he shall take loan. 2. Ms X is having Rs 5 lakhs that she is willing to invest profitably and without much
risk.
If we analyse carefully we can elaborate the problems as follows –
1. Which bank offers the cheapest interest rates? What will be the repayment period ? What will be the instalment per month? How much instalment Mr A can afford, considering his all other expenses? and so on
2. Whether to invest in government securities, Provident fund, Mutual funds, Debentures, Shares, gold or real estate ?
To put it simply we can say that Mr A is facing a problem about procurement of funds whereas Ms X is facing problem as to investment of funds. Financial Management provides guidelines , tools and methods of solving the problems of procurement of funds and problems of investment of funds and is helpful for every organisation as well as individual.
1.2 Meaning of Financial management
Various authors have defined the term financial management differently. The most acceptable definition of financial management deals with procurement of funds and their effective utilisation. There are, thus, two basic aspects of financial management – procurement of funds and their effective utilisation.
1.2.1 Procurement of funds – Procurement of funds or raising the funds is complex problem as funds can be obtained from indefinite sources, each having different characteristic in terms of risk, cost and control. E.g - let us evaluate some sources of funds (For detailed discussion of sources of funds refer following topics - cost of capital and sources of funds)
Risk High Cost Low R (Bank loan) I S K Cost High Risk Low (Equity shares) C O S T
Again Control risk is least for bank loan where as it is highest for Equity shares. One more constraint for procurement of funds is availability of funds e.g for a small business house only availability may be bank loan and the business may not be able to raise funds from public by way of equity shares.
Procurement of funds inter alia includes –
• Identification of sources of finance
• Determination of finance mix from such sources
• Raising of funds
• Allocation of profits between dividends and retention of profits i.e internal fund generation
In the current global scenario it is not enough to scout for available ways of raising finance but resource mobilisation has to be undertaken through innovative financial products which understand the business as well as investors needs an example can be convertible debentures which gets converted from debentures to equity shares after a predefined date.
1.2.2 Utilisation of Funds - A finance manager is also responsible for effective utilisation of funds. He is responsible to ensure that the funds are not kept idle and are invested properly. Utilisation of funds can be directly linked with the procurement of funds, if the funds are not utilised to generate income higher than the cost of procuring it then there is no point in running the business, say, for example if a bank is offering 5% interest on deposits then the banker must ensure that the amount of deposit is utilised to generate an income which is higher than 5%.
The funds have to be so invested that the company can optimise its profitability without harming its solvency and liquidity. The finance manager has to invest in fixed assets and current assets in a right proportion so as to reap maximum yield.
Utilisation of funds inter alia includes –
• Identification of area of investments
• Determination of finance mix for the utilisation
• Assessing the risk level of the investment
In present day scenario utilisation of funds can be done in indefinite ways making the job of finance manager more complicated and demanding. Following chart indicates the decision-making options available to a finance manager for utilisation of its funds.
Risk High Returns high R (Equity market) I S K Risk Low Return Low (Government Security) R E T U R N
1.3 Importance of Financial Management
The importance of finance manager cannot be over-emphasised. There is an ordinary belief that a finance manager is needed only in private organisations. However, sound finance manager is essential in all organisations – whether profit or non profit where funds are involved. Financial management is so essential as he plays a crucial role in making best use of resources. Commercial history is full of examples where firms have been liquidated not because their technology was obsolete or it lacked demand for its products but because of financial mismanagement, a recent example of ENRON INC can be very elaborative about this point.
Financial management essentially optimises the output from the given input of funds. It attempts to use the funds in most productive manner. In underdeveloped countries like India where resources are scare and demands on funds are many, the need for finance manager is enormous.
Finance management can be very effective in case of non-profit making organisations as which hardly pay proper attention to financial management. Very frequently we read about such organisations closing down because of lack of finance, in fact, many times, it is not lack of finance but it is lack of proper financial management. Many times these organisations keep their funds idle which has cost. Though motive of such organisations is not to make profits but it can certainly cut down its costs in order to have sound financial position.
An example - Following extract is taken from board report of a company emphasising the turnaround in company’s financial position achieved due to sound financial management –
“Better cash management and control over capital employed and working capital has helped the company in reducing its loans from Rs 580 crores to Rs 200 crores resulting into interest saving of approx Rs 30 crores, this has improved profit position of the
company substantially. We hope to continue with similar performance in current year by undertaking further cost cutting and strict control over cash flows.”
1.4 Objectives of Financial Management – A basic understanding of objectives of financial management would help us in appreciating how a finance manager makes his decisions. Decisions can be made only when objectives are clear. Following are the fundamental objectives of finance manger –
1.4.1 Profit Maximisation – It cannot, however, be the sole objective of the company, but it is certainly one of the most important objectives. If a company is run with sole object of profit making then it can create certain problems like –
i. Profit maximisation has to be attempted with a realisation of risks involved. Risk and profit is directly relates and motive of profit maximisation may lead to risk maximisation also. A finance manager with sole objective of profit maximisation may end up taking excessive risk, which may lead to failure of organisation. In practice, risk is given almost equal importance as that of profit and profit is maximised only till it reaches the acceptable risk level.
ii. Profit maximisation may or may not take into account the time pattern of return i.e even if Project A is having more profit than Project B, project A may start giving return at the end of year 5 and Project B at the end of year 1. In such scenario finance manager has to consider both the things time and profit and not only profit.
iii. Profit maximisation is a very narrow object and does not take into consideration social aspects, which can be very harmful to the society.
1.4.2 Wealth Maximisation –The policy of profit maximisation is considered as short-term policy as it may give exorbitant benefits in short short-term but may end up affecting growth and survival of the company in the long run. Thus a company may start buying inferior raw materials in order to maximise profit, which it may actually get for some period, but will end up losing its goodwill and may have to close down.
Hence, it is commonly agreed that the objective of a firm is to maximise its value or wealth. According to Van Horne – “Value is represented by the market price of the company’s common stock ………… The market price of a firm’s stock represents the focal judgement of all market participants as to what the market value of the particular firm is. It takes into consideration present and expected future earnings per share, the timing and the risk associated to the earning, company’s dividend policy etc.. The market price serves as performance indicator of the firm; it indicates how well management is doing on behalf of the stockholders.”
Though market value of the firm depends upon various factors, it normally depends upon two
Factors –
a. The likely rate of earnings per share of the company (EPS) b. The Capitalisation rate
Let us see one example. If for a company A ltd the market expectation of returns is 25% and it’s Earnings per share is Rs 5 (EPS = Earnings available to equity share holders/ no of equity shares outstanding) then the market price per share will be –
5/25*100 = Rs 20 per share. If we calculate in reverse way we can see that the return on every Rs 20 invested the shareholder will be getting Rs 5 i.e 25% which is as per his expectations. The expected return varies form company to company and industry to industry (which is 25% for A ltd), the logic for expected returns is simple - more the risk more will be the expected returns.
The finance manager has to ensure that his decisions are such that the market value of the shares of the company is maximum in the long run. It is, therefore, duty of the finance manager to optimise the earning of the company so that its value is maximum. Wealth maximisation can thus be considered a better objective as it considers both risk and return of the company.
It must be clearly understood that financial decision-making is related to the objective of business and objective of business over shadows the objective of wealth maximisation. To support the statement the following example can be taken – suppose a Public sector under taking, which is in business of steel pipes, is planning to undertake a research and development programme on fertility of baron lands for public welfare, then the finance manager cannot deny funds stating that this is wastage of funds and it wouldn’t maximise the company’s wealth.
1.5 Functions of Finance Manager
The main function of finance manager revolves around procurement of funds and its effective utilisation. Thus all the decisions concerning management of funds are subject matter of finance function. This function involves a number of important decisions; some of these have been listed below –
1.5.1 Estimating the requirements of funds - In any business requirement of funds have to be carefully estimated. Certain funds are required for long term purposes i.e investment in fixed assets etc. Not only a careful estimation of such funds is required but also estimation of timing of its requirement is essential. Finance Manager also has to estimate the requirement of the working capital and how much funding will be required for funding its current assets. Forecasting these requirements require budgetary controls and techniques. To forecast the funds requirement all the physical activities of the organisation has to be forecasted like sales, requirement of fixaed assets, debtors etc.
1.5.2 Decision regarding the capital structure – After estimating the quantum of funds required the finance manager has to plan for the sources from where the funds should and can be raised. An optimum mix of the various sources has to be worked out for this purpose. As discussed earlier each source of finance has different cost, risk and
control risk, a finance manager has to take into consideration all these factors and find out an optimum capital structure which will be best for the organisation. Finance manager has to maintain a proper proportion of outside borrowings and own funds. Again as every other decision this decision should also aim at wealth maximisation, which can be achieved by keeping the cost of capital (borrowed from outside as well as own funds) minimum. This is a golden rule of capital structure theories that lesser the cost of capital higher will be the market value of the business.
1.5.3 Investment decision – Funds procured should be invested in various kinds of assets. Long term loans / funds should be invested in Fixed assets and short term funds should be invested in current assets. The investment in any asset should be made after through examination of all the options, the technique for examining various capital projects is termed as capital budgeting. One thing a finance manager should always keep in mind is that money should never be kept idle as idle money always has a cost. 1.5.4 Dividend decision – The finance manager is concerned with the decision to the decision to declare and pay the dividends periodically, so that the equity investors get return on their investments. He has to help the top management in identifying how much amount can be distributed as dividends, keeping in mind organisations cash needs, expansion plans etc.. There are many other factors on which this decision depends like trend of earnings, the trend of market price of the shares, the tax implications etc.
1.5.5 Supply of funds to all departments and cash management – Though not a primary function, cash management and funds allocation is an important function of a finance manager. It is more than likely in any organisation that one branch or department is having excess cash and other may be having a shortage, this may hamper company’s day to day functioning as adequate funds is a necessity for smooth running of any business. Finance manager should ensure that cash is not kept idle as it may cost the organisation heavily.
1.5.6 Evaluating financial performances – Finance manager is always required to do the job of performance evaluator of the company. He has to supply top management information with financial analysis. Analysis of financial performance helps the management in seeing how the funds have been utilised in various divisions and what can be done to improve it.
1.5.7 Financial negotiations – A major responsibility of finance manager is to negotiate with bankers, financial institutions providing loans, debenture investors etc. Negotiation for finance is considered as a specialised job and involves lots of expertise. 1.5.8 Maintaining the share price of the company – stability in market price of the shares is extremely essential for every organisation as it maintains the company’s goodwill amongst the investors. It is responsibility of Finance manager to see that the prices of shares do not fluctuate extremely.
1.6 Financial management and organisational structure –
The chief financial executive (his designation may vary from company to company) works directly under the president or Managing director of the company. Besides routine work, he keeps the Board of directors informed about all the phases of business activity, including economic, social and political developments affecting the business behaviour. He also furnishes information about the financial status of the company by analysing it from time to time. The chief financial executive may have many officers under him to carry out his functions. Broadly, his functions are divided into two channels –
A. Treasury functions B. Control functions
The above statement is elaborated in the following chart Board of directors
Managing director / President
VP (Marketing) V.P. (Finance) V.P
(Prodn.)
Treasurer
Credit Management Cash Management Banking Portfolio management
Controller
Financial Accounting Taxes Internal audit Budgeting MIS & Cost accounting
1.6.1 Relationship of finance manager with other managers
Finance function can never be an independent function and is closely related with other management functions like production, marketing, personnel etc. we’ll take a close look at how these functions are co related, in order to understand position of finance manger in the organisation. Finance is blood of an organisation. It is the common thread which binds all the organisational functions as each function when carried out creates financial implications. The interface between finance and other functions can be described as follows –
Production – Finance – Production Function necessitates a large investment. Productive uses of resources ensure a cost advantage for the firm. Optimum investment in inventories improves profit margins. Many parameters of the production function having effect on production cost or possible to be controlled through internal management, thus improving profits. One of the important decisions taken by Finance – Production departments together is the make or buy decision. In current scenario this decision has lead to heavy outsourcing to low cost countries. Marketing – Finance – Many aspects of marketing management have direct
financial impact. How much inventory shall be hold so that prompt delivery can be guaranteed to the customer, has a direct impact on inventory holding cost of the company. Similarly credit period granted to customers by the marketing department directly affects the liquidity position of the company. Marketing campaigns and advertisements have huge cost and should always co-related with the revenue which it generates.
Personnel – Finance – In the globalised competitive scenario business firms are moving to leaner and flat organisations. Investments in human resource development are also bound to increase. Restructuring of remuneration structure, Voluntary retirement schemes, stock options etc. have become major financial decisions in the areas of human resources management.
1.7 Changing face of financial management in India
India has witnessed tremendous change in the concept of financial management ever since a the last decade. Ever since the Indian market opened up, Indian corporate sector has access to global financial markets. Currently there are unlimited opportunities available to the corporate sector in India to invest as well as borrow from foreign markets and to maximise the benefit by considering these increased options. Financial products like options, swaps, American depositary receipts (ADRs), Global depositary receipts (GDRs) etc. were totally unheard a few years ago. Some of the key indicators of changing era and reasons for this changing era are -
a. Rupee has become fully convertible on current account b. Industrial licensing has been abolished
c. Allowing foreign institutional investors (FII) to invest in Indian market d. Allowing Foreign direct investment (FDI), though upto certain extent
e. Allowing abroad listing of Indian companies e.g ICICI is listed in New york stock exchange.
f. Share prices of new share issue are no longer regulated by the government g. ECB- External commercial borrowing is allowed.
h. NRIs and OCBs are allowed to invest in unlisted companies.
Though the changing financial market is outcome of several factors, the above mentioned factors are landmarks.
1.8 Self-examination questions
Write notes on –
1. The objectives of financial management
2. Distinguish between “Profit maximisation” and “Wealth maximisation”
3. Draw and explain organisational chart of a finance manager and his relationship with other departments
4. Discuss Functions of a Finance manager
5. Discuss how financial management is changing in Indian scenario
6. What are the important aspects of procurement of funds and its utilisation Select the correct options –
1. Which of the following are the functions of a Finance Manager a. Negotiating loans with bankers
b. Internal audit
c. Deciding the advertiser
d. Deciding company’s recruitment policies e. Cash management
2. The primary objective of a finance manager is a. Wealth maximisation
b. Profit maximisation c. Both of the above d. None of the above
3. Financial management is essential for – a. Private sector enterprises
b. Public sector enterprises c. Social organisations d. All of them
e. None of them
4. The value of a company is reflected by – a. Profit of the company
b. Number of employees c. Total assets of the company
5. What are the key aspects a finance manager must think before procuring the funds
a. Risk
b. Cost of the funds c. Control risk d. All of the above e. None
6. To maximise the value of the company; cost of capital should be – a. minimum
b. maximum
c. company value doesn’t depend upon cost of capital 7. The cost of capital for a high risk project will be –
a. high b. low c. zero
2 Financial planning and forecasting
2.1 Introduction
Estimation of requirement of finance is essential before deciding the amount of funds that needs to be raised. Financial management provides various tools for this estimation commonly known as ‘Budgeting’. A finance manager has to prepare budgets periodically and accurately as inaccurate budgets may lead to either under financing or excess financing, both of which are detrimental to the interests of the organisation. The term accurate does not imply accuracy to last rupee but indicates a fairly accurate estimate. Timely preparation of budgets is necessary as with the help of budgets funds can be raised timely and smooth flow of operations can be ensured.
2.2 What is financial planning and nature of financial planning
J.H.Bonnerville defined financial planning as “ the financial planning of a corporation has a two fold aspects, it refers not only to the capital structure of corporation but also to the financial policies which the corporation has adopted or intends to adopt.”
According to Solomon and Pringle “narrowly conceived, financial planning may refer to the process of determining the financial requirements and financial structure necessary to support a given set of plans in the other areas”
Above two definitions highlight following aspects of Financial management – 1. It determines the requirement of finance
2. Financial planning is a process and not just a one time activity
3. It invariably includes plans of other areas like production, marketing etc. 4. It covers both capital structure and financial policies
Financial planning should always be bifurcated between long term planning and short term planning. Long term financial planning includes designing of the capital structure of the company, estimating requirements for long term funds, planning amount of investment in long term assets etc. Short term planning mainly includes planning and estimating working capital requirements and cash budgeting. Long term planning may be for up-to 5 to 20 years, whereas generally short term plans are for 1 to 2 years. The budgeting process covers estimates of almost all departments like Marketing, Production, Human resources, administration etc. The starting point of all the budgets is always the sales figure. Almost all the figures can be derived based on estimated sales. It should be noted that the sales figure and most of the other incomes and expenses are not only estimated in terms of money but also in terms of quantity for budgeting purposes.
Estimation of requirement of investment for expansion of production capacities from sales figure can be determined as follows –
Sales (Rs.)
Sales (Units)
Estimated production required for estimated sales
Currently available production capacity
Estimated Production capacity required to cover the shortfall
Estimated expenditure involved to set-up such production facility*
*- Please note that it is not necessary that the organisation will go for expansion based on the estimated requirement. Before expansion it will have to consider various factors and take various decisions like whether the increased demand is seasonal or permanent, whether to make or buy the product, whether demand is sufficiently high to cover the additional expenditure.
It is imperative to note that planning is not only useful for predicting the requirement of funds but also it is an important control device for the management. Every department is answerable for spending more than the budgeted figures and earning lesser than the budgets.
2.3 Need and importance of financial planning
The need and importance of financial management can never be over emphasised. Following points briefly highlight the need and importance of financial management –
a. Ensuring enough liquidity i.e sufficient availability of cash balance b. Determining the timing and extent of borrowings
c. To anticipate requirements of funds
d. To minimise the cost of funds by looking for opportunities to invest idle funds
e. To maintain company’s solvency 2.4 Factors to be considered in a financial plan
Nature and seasonality of business – Nature of business plays a decisive role in financial planning. The requirement of funds, its timing and type wholly depends upon the business in which the organisation operates. Capital intensive industry requires heavy investment in long term finance like cement industry, aviation industry steel industry etc. whereas labour intensive organisations require comparatively higher funds for short term funding like Information technology. Financial plan must consider these requirements of the industry before forecasting the results. Again seasonality of business is certainly a dominating factor. For example If the finance manager is making finance plan for a air conditioner manufacturing company based the estimates that sales for the year will be Rs 360 lacs and so per month will be Rs 30 lacs and hence the working capital requirement will be Rs xxxxxx . Here it is more than likely that his estimation is wrong as ACs are sold more in summers i.e from March to May and is sold lesser in winters, so the basic estimate of sales per month itself is wrong as failed to appreciate seasonality of his business. This will obviously lead to over financing in winters and under financing in summers.
It may be noted here that almost all the businesses have some sort of seasonality that the finance manager should be aware of before preparing the finance plans.
Contingencies - A Finance manager should always make room for contingencies while making a finance plan. He should make some provisions for unforeseen risks otherwise he may fail to give a good finance plan.
Management perceptions - Before deciding the sources of funds in a finance plan a finance manager must take into consideration management perceptions about risk, cost and control risk involved in raising finance. For example if management is not interested in diluting the control of existing shareholders then it may reject any proposal of raising funds through equity shares. If management is not prone to taking risks then perhaps large bank loans may never be raised by the organisation.
Analysis of all the available alternatives – A finance manager must consider all the available alternatives, analyse its advantages and disadvantages, before deciding upon the mix that will be best for the interest of the organisation.
Government policies – In preparing a financial plan, finance manager has to invariably take into account various government policies and controls. He must take full advantage of the government subsidies and other benefits made available by the government.
Expansion plans – Expansion plans must be considered before deciding upon any finance plan as generally expansion plans require huge investments and may affect significantly all the other estimates.
Inflation - A finance plan made by individuals also take into account inflation, so it is almost unnecessary to mention inflation as a major consideration for a fiancé plan. It is not necessary that inflation will only inflate the projected expense figures and will reduce
the estimated profit figures, on the contrary inflation may increase the sales figures more than the expenses and may result into more profit (estimated).
Uniqueness of the organisation – All the companies cannot have a similar finance plan as each unit is unique in itself and will require different finance mix to suit its needs. Again its not possible that all the units have access to all kinds of finances and then the finance plan should only consider whatever options are available to the particular units.
2.5 Essential characteristics of financial plan
Though finance plan of every organisation is unique it invariably should have following characteristics in common –
2.5.1 Simplicity – Simplicity is a requirement for every plan let alone financial plan. All the financial plans should be simple and self content , so that it is more understandable even to non finance members of the management.
2.5.2 Flexibility – Rigid financial plans can never be successful all financial plans needs some sort of flexibility. It can be noted that what we have discussed till now about financial plan is that it is an estimation, and its nearly impossible to estimate with 100% accuracy. To cope up with this drawback in the estimates financial plans should be kept open for any unseen material changes that may occur in future.
2.5.3 Completeness – Completeness implies that whether all the estimates are considered in the financial plan or not. It should never happen that some department or some major expenses are completely missed out from the financial plans. Ensuring completeness is perhaps one of the most difficult task which a finance manager faces.
2.5.4 Vision – Vision and foresight is an absolute essential characteristic of any financial plan. Financial plan is not merely mathematical job but it involves thinking and foresight
2.5.5Control - Financial plans or budgets should be able to serve as a control tool by the management. The budgeted figures should be compared with the actual performance so that inefficiencies in the organisation can be controlled.
2.6 Budgeting
Budgeting is a process comprising of designing, preparation, implementing and operating financial plans. Budget is an estimation as well as target. One of the most significant aspect of budgeting is that it helps in establishing responsibilities at various
levels, as budgets are prepared department / branch / cost centre wise and each department head is responsible for following that budget. The ultimate budget encompassing most of the operations of the firm is known as ‘Master Budget’ and may comprise of the following –
1. Capital budgeting
2. Financial budgets – Cash budgets and projected financial statements (profit and balance sheet budgets)
3. Operating budgets – sales budget, production budget purchae budget etc.
2.6.1 Cash Budgets- Cash budgets are prepared periodically to identify cash inflows and outflows, as cash flows determine the requirement of funds and helps identifying investible funds. Cash budgets are nothing but cash flow statements. One must note that cash flow is different from profit or loss, to identify cash flow one must adjust all non cash items to the profit / loss. Other popular way for preparing cash budgets is to prepare estimated receipts and payments account.
2.6.2 Projected financial statements - The projected financial statement means projected Balance sheet and Profit and loss account. The requirement for preparing this budgets is financial statements of earlier periods and operating budgets.
2.7 Solved problems on Budgeting Problem 2.7.1
From the following information prepare balance sheet of A ltd. for the year ending on 31.3.2005 1. Financial position as on 1.4.2004 Rs. 000’s a. Share capital 7,50 b. Reserves 10,00 c. Debentures 50 d. Bank Loan 2,00 e. Current liabilities 2,00 Total Liabilities 22,00 a. Debtors 5,00 b. Inventories 3,00
c. Fixed assets (net) 11,00
d. Cash 1,00
Total Assets 22,00 2. Estimates for 2004-05 Rs. 000’s a. Sales (Credit) 20,00 b. Cost of production 17,00 c. Depreciation 1,00
d. Selling and distribution costs 2,00
e. Collection from debtors 22,00
f. Increase in current liabilities 50
g. Closing stock 6,00
h. Debentures refunded 50
i. Dividend paid 1,00
Solution –
Projected Balance Sheet as at 31/3/2005
Rs. 000’s
Liabilities Amount Assets Amount
Share Capital 7,50 Fixed Assets (net) 10,00
Reserves 12,00 Investments 2,00
Bank Loan 2,00 Debtors 3,00
Current Liabilities 2,50 Inventories 6,00
Cash Balance 3,00
Total 24,00 Total 24,00
Working Notes –
1. Debtors = Opening Debtors + Credit sales – Collections = 5,00,000 + 20,00,000 - 22,00,000
2. Projected Income statement
Projected Profit & Loss Account for the year ended 31/3/2005
Rs. 000’s Rs.
000’s
Opening stocks 3,00 Sales 20,00
Cost of Production 17,00 Closing stock 6,00
Selling and distribution costs 2,00
Net profit 3,00
Total 26,00 26,00
3. Profit transferred to reserves
Net profit for the year ended 31/3/2005 Rs.3,00,000
(-) Dividend declared and paid 1,00,000
Transfer to reserves 2,00,000
4. Fixed assets = Opening balance – Depreciation = 11,00,000 – 1,00,000 = 10,00,000 5. Projected cash balance
a. Opening Cash balance 1,00,000
b. Collection from debtors 22,00,000
c. Increase in current liabilities 50,000 Total receipts 23,50,000 Less : a. Cost of production 17,00,000 b. Variable cost 2,00,000 c. Debentures repaid 50,000 d. Payment of dividend 100,000 Total Payments 20,50,000
Net Cash balance 3,00,000
Problem 2.7.2
Following is the summerised Balance sheet of the Progressive Corporation Ltd. as on 31st December, 1998
Liabilities Rs. Assets Rs.
Share Capital 8,00,000 Fixed assets 4,48,000
Reserves 11,84,000 Stocks 11,52,000
Creditors 6,40,000
32,00,000 32,00,000
Other Information
1. Trade creditors are equal to last months purchases and debtors are equal to last two months sales (for both the years)
2. For the half year ended on 31.12.1998 sales amounted to Rs 50,42,000 and gross profit earned at an uniform rate was Rs 10,08,000
3. With effect from 1.1.1999 goods purchased will cost 25% higher and sales price will be increased by 20%
4. Sales and purchases are spread evenly throughout the year
5. Value of closing stock on 30.6.1999 is expected to be 10% higher than on 31.12.1998
6. Expenses other than purchases amounts to Rs 64,000 per month 7. No fixed assets are proposed to be sold or acquired during the period
You are required to prepare Projected Balance sheet and Profit & loss account for half year ending 30.6.1999.
(CS Final Dec) Solution
Projected Balance sheet as at June 30, 1999
Liabilities Rs Assets Rs
Share capital 8,00,000 Fixed assets 4,48,000
Reserves
(including profit for the year)
21,65,000 Stocks 12,67,200
Trade creditors 8,00,000 Debtors 20,16,800
Cash 33,600
37,65,600 37,65,600
Working notes –
1. Debtors = 2 months sales = (50,42,000*120%) / 6*2 = 60,50,400/3 =20,16,800 2. Creditors = 125% (last years creditors) = 125% * 640,000 = 8,00,000
3. Cash figure is balancing figure
Projected Profit & loss Account
Rs Rs
To opening stock 11,52,000 By sales 60,50,400
To Purchases 48,00,000 By Closing stock 12,67,200
To gross profit 13,65,600
73,17,600 73,17,600
To other expenses 3,84,000 By Gross profit 3,65,600
To net profit 9,81,600
37,65,600 37,65,600
Working notes –
1. Purchases = 6 months creditors (as creditors are one months purchases) = 6 * 8,00,000 = 48,00,000
2. Sales = 120% (last years sales) = 120% (50,42,000) = 60,50,400 3. Other expenses = 64,000 * 6 = 3,84,000
Problem 2.7.3
You are required to make a projected income statement and projected balance sheet for the year 1995-96 on the basis of following information available for 1994-95
Sales Rs 10 Crores
Expected growth rate 40%
Net profit margin 20%
Dividend paid (as % of net profit) 40%
Tax rate 50%
Balance sheet as on 31.3.95
Liabilities Rs.
lakhs Assets Rs lakhs
Share capital 175 Fixed assets 400
Retained earnings 150 Current assets 470
Current liabilities 545
You may make necessary assumptions (CWA final Dec 95)
Solution :
Projected Income statement for 1995-96
Rs. Lakhs
Sales (40% increase) 1400
Profit before tax 560
Less : Tax @ 50% 280
Profit after tax (20% of sales) 280
Less : Dividend (@ 40 % of above) 112
Retained earnings 168
Working notes
1. Sales are 40 % above previous years sales of Rs 1000 lakhs = 140% (Rs. 1000 lakhs) = Rs 14 crores
2. Net profit margin is stated to be 20% of the sales i.e Profit after tax = 20% (Rs1400 lakhs) = Rs 280 lakhs
3. As Net profit is after deducting tax of 50%, profit before tax is double of profit after tax i.e Profit before tax = Rs 280 lakhs * 2 = Rs 560 lakhs
4. It is assumed that the 40% increase in sales is also reflacted in increse in current assets and liabilities
Projected Balance sheet as on 31.3.96
Liabilities Rs.
Lakhs Assets Rs lakhs
Share capital 175 Fixed assets 400
Retained earnings 318 Current assets 658
Current liabilities 763 Cash 310
Proposed dividend 112
Working notes
1. Current liabilities and current assets is taken as 40% above previous years figures i.e Current liabilities = 545 * 140% =Rs 763 lakhs, Current assets = 470 * 140% = Rs. 658 lakhs
2. Cash is balancing figure
3. It is assumed that there is no increase in share capital and Fixed assets.
Problem 2.7.4 (Cash budgeting)
R ltd. has decided to raise Rs 80 lakhs for a proposed new project. The management has decided to raise half of the required funds through equity shares and half through bank loan.
The estimated cash flows are as follows – Initial outlay (In April 2004)
Land Rs 30,00,000
Machinery Rs 20,00,000
Stocks Rs 10,00,000
Other assets Rs 6,00,000
Estimated sales and purchases for the period April to September 2004 is as follows April – Sales (S) = Rs 14 lakhs, Purchases (P)= Rs 10.40 lakhs
May – S = Rs 15 lakhs, P = Rs 11.20 lakhs June– S = Rs 18.5 lakhs, P = Rs 14 lakhs July – S = Rs 25 lakhs, P = Rs 19.05 lakhs August – S = Rs 26.5 lakhs, P= Rs 20.25 lakhs September – S = Rs 28 lakhs, P = Rs 21.45 lakhs
Other information –
1. Debtors are given 2 months credit period and creditors give 1 months credit period.
2. Preliminary expenses Rs 50,000 payable in May 3. General expense paid in each month Rs 50,000
4. Monthly salaries payable next month – Rs 80,000 for three months and Rs 95,000 there after
Prepare a cash budget for the six months and calculate estimated cash balance as at each month end
Solution :
Rs lakhs
April May June July August September
Opening cash balance - 13.50 1.30 2.80 2.50 0.50
Receipts:
Issue of shares 40.00 - - - --
-Issue of debentures 40.00 - - - -
--Collection from Debtors - - 14.00 15.00 18.50 25.00
Total receipts (i) 80.00 13.50 15.30 17.80 21.00 25.50 Payments :
Purchase of land 30.00 - - - -
-Purchase of Machinery 20.00 - - - -
-Purchase of other assets 6.00 - - - -
-Preliminary expenses - 0.50 - - -
-Paid to creditors 10.00 10.40 11.20 14.00 19.05 20.25
Salaries - 0.80 0.80 0.80 0.95 0.95
General expenses 0.50 0.50 0.50 0.50 0.50 0.50
Total payments (ii) 66.50 12.20 12.50 15.30 20.50 21.70 Net cash balance (i-ii) 13.50 1.30 2.80 2.50 0.50 3.80 Problem 2.7.5
B Ltd. has following balance sheet for the year ended on 30th June 2000
Liabilities Rs. Assets Rs.
Share capital 1,00,000 Fixed assets 1,26,000
Profit & loss 44,600 Stocks 25,000
Trade creditors 25,000 Bank 3,000
Other creditors 9,000 Debtors 24,600
1,78,600 1,78,600
The budget committee has given following forecast for the six months ended 31st
December 2000:
Month Sales in units
Purchases Salaries Overhead s Purchase of Fixed assets Issue of shares May 4000 12,000 8,000 7,000 June 4200 13,000 8,000 7,000 July 4500 14,000 8,000 7,000 August 4600 18,000 10,000 7,000 Septembe 4800 16,000 10,000 7,000 20,000
r
October 5000 14,000 10,000 8,000
November 3800 12,000 12,000 8,000 30,000
December 3000 12,000 12,000 8,000
You are given the following information
1. The selling price in May 2000 was Rs. 6 per unit and this is to be increased to Rs 8 per unit in October 50% of sales are for cash and 50% on credit to be paid 2 months later
2. Purchases are to be paid 2 months after purchases
3. Wages are to be paid 75% in the month incurred and 25% in the following month 4. Overheads are to be paid for in the month after they are incurred
5. Fixed assets are to be paid in three equal monthly instalments starting from the month of purchase
6. Other income received in the month of August Rs 2,600 and December Rs 2,500 Prepare a cash budget from the following information
Solution:
Monthly Cash budget for the period ended Dec. 31,2000 July August Septembe
r
October November December
Opening Balance 3,000 1500 1,000 17,900 16,700 10,800 Receipts: Cash sales 13,500 13,800 14,400 20,000 15,200 12,000 Collection from debtors 12,000 12,600 13,500 13,800 14,400 20,000 Issue of capital - - 20,000 - - -Other income - 2,600 - - - 2,500 Total 28,500 30,500 48,900 51,700 46,300 45,300 Payments : Creditors 12,000 13,000 14,000 18,000 16,000 14,000 Salaries – Current month 6,000 7,500 7,500 7,500 9,000 9,000 - Previous month 2,000 2,000 2,500 2,500 2,500 3,000 Overheads 7,000 7,000 7,000 7,000 8,000 8,000 Fixed assets - - - 10,000 Total 27,000 29,500 31,000 35,000 35,500 44,000 Closing balance 1,500 1,000 17,900 16,700 10,800 1,300
2.8 Self examination Questions
1. What do you understand by financial planning ? explain the characteristics of a sound financial plan ?
2. You are requested to do financial planning for a newly manufacturing company to be set up. What important considerations you take into account in doing so? 3. What is budgeting ? discuss various types of budgeting and its importance ? 4. MA Limited is commencing a new project for manufacture of a plastic component
The following cost information has been ascertained for annual production of 12,000 units which is full capacity.
Cost Per unit (Rs.)
Materials 40
Direct labour and variable expenses 20
Fixed manufacturing expenses 6
Depreciation 10
Admin expenses (fixed) 4
Total 80
The selling price per unit is expected to be Rs 96 and selling expenses Rs 5 per unit 80% of which is variable
In first two years production and sales are expected to be – Year 1 – sales = 5000 units, Production = 6000 units
Year 2 – Sales = 8500 units, Production = 9000 units
You are required to prepare projected profit & loss account for both the years 5. X ltd. has decided to raise Rs 160 lakhs for a proposed new project. The
management has decided to raise 2/3rd of the required funds through equity
shares and remaining through Debentures. The estimated cash flows are as follows – Initial outlay (In April 2004)
Building Rs 60,00,000
Machinery Rs 40,00,000
Stocks Rs 20,00,000
Cars Rs 12,00,000
Estimated sales and purchases for the period April to September 2004 is as follows
April – Sales (S) = Rs 42 lakhs, Purchases (P)= Rs 32 lakhs May – S = Rs 45 lakhs, P = Rs 36 lakhs
June– S = Rs 50 lakhs, P = Rs 42lakhs July – S = Rs 52 lakhs, P = Rs 45 lakhs August – S = Rs 52 lakhs, P= Rs 47 lakhs
September – S = Rs 54 lakhs, P = Rs 47 lakhs
Other information –
1. 50% sales are on credit and Debtors are given 2 months credit period and creditors give 1 months credit period.
2. Preliminary expenses Rs 150,000 payable in May 5. General expense paid in each month Rs 85,000
6. Monthly wages payable next month – Rs 1,80,000 for three months and Rs 125,000 there after
Prepare a cash budget for the six months and calculate estimated cash balance as at each month end
6. D Ltd. has following balance sheet for the year ended on 30th June 2000
Liabilities Rs. Assets Rs.
Share capital 1,20,000 Fixed assets 26,000
Profit & loss 24,600 Stocks 1,25,000
Trade creditors 5,000 Bank 13,000
Other creditors 29,000 Debtors 14,600
1,78,600 1,78,600
The budget committee has given following forecast for the six months ended 31st
December 2000:
Month Sales in units
Purchases Salaries Overhead s Purchase of Fixed assets Issue of shares May 14,000 82,000 18,000 7,000 June 14,200 83,000 18,000 7,000 July 14,500 84,000 18,000 7,000 August 14,600 88,000 20,000 7,000 Septembe r 14,800 86,000 20,000 7,000 30,000 October 15,000 84,000 20,000 8,000 November 13,800 82,000 22,000 8,000 58,000 December 13,000 82,000 22,000 8,000
You are given the following information
7. The selling price in May 2000 was Rs. 16 per unit and this is to be increased to Rs 18 per unit in October 50% of sales are for cash and 50% on credit to be paid 2 months later
8. Purchases are to be paid 2 months after purchases
9. Wages are to be paid 75% in the month incurred and 25% in the following month 10.Overheads are to be paid for in the month after they are incurred
11.Fixed assets are to be paid in three equal monthly instalments starting from the month of purchase
12.Other income received in the month of August Rs 2,600 and December Rs 2,500 Prepare a cash budget from the following information
2.8.1 Objective questions
1. --- involves planning for cash inflows and out flows
2. The most important function of financial planning is anticipating ---. 3. Financial plan should have following characteristics
a. Simplicity b. Flexibility c. Foresight d. Completeness e. All of the above
4. Choose the considerations which a Finance manager has to follow while making a financial plan
a. Nature of business b. Inflation
c. Seasonality of business d. Attitude of management e. All of the above
f. None of the above
5. The uses of preparing a budget are –
a. Estimating the requirements of funds b. Control
c. Deciding capital structure d. Preparation of Balance sheets
f. All of the above g. Options a, b and c h. Options b,c,d and e
6. Do you agree with the following statements – a. It determines the requirement of finance
b. Financial planning is a process and not just a one time activity
c. It invariably includes plans of other areas like production, marketing etc. d. It covers both capital structure and financial policies
3 Operating and financial leverage, cost
volume profit analysis
3.1 Introduction
After ascertaining the financial requirements through a financial plan a manager has to ascertain the source of finance from where he should raise the funds. This decision depends upon how each type of funds affects the risk and returns of shareholders. Leverage analysis is one of the technique used to ascertain and quantify the firms risk return relationship of different alternative capital structures.
3.2 Types of leverages
Leverage represents the ratio of one financial variable to some other related financial variable. In short it quantifies the expected change in one financial variable with respect to other related financial variable. There are three common types of leverages used in financial management –
1. Operating leverage 2. Financial leverage 3. Combined leverage
Operating leverage [OL] – This ratio quantify the change in Earnings before interest and tax (EBIT) on account of change in contribution. All the costs can be bifurcated between two parts
i. Variable costs ii. Fixed costs
Variable costs is the cost which varies with the production whereas fixed cost remains constant. An example can be taken to elaborate this statement – consumption of raw materials varies with the production i.e if a component x requires y units of raw material then for production 2x quantity required will be 2y. Whereas some expenses like rent remains the same even if there is no production or production is 100%. It can be appreciated here that as the production goes up variable cost will also go up, but fixed cost is bound to remain same, increasing the profits of the company.
Illustration –
Company A manufactures plastic components, its cost structure is a s follows – Selling price per unit Rs 5, Cost of materials per unit Rs 3, Rent paid by the company Rs 1000 p.m
Company A sold 1000 units in month of march and 2000 units in month of April calculate its contribution and EBIT for both the months
Solution –
Rs.
March April
Sales (No of units * selling price) 5,000 10,000 Less :
Variable costs – Materials 3,000 6,000
Contribution 2,000 4,000
Less :
Fixed costs – rent 1,000 1,000
EBIT 1,000 3,000
It is clearly evident from above solution that though contribution as percentage of sales remains same i.e. 40%, EBIT as percentage of sales has gone up from 20% to 30%. This is because what we can call spreading of fixed expenses over a lager amount of sales.
Operating leverage = contribution = % Change in EBIT
EBIT % Change in sales
In current problem = 100% / 200% i.e. 2
So we can state from this that for every 1% change in contribution there will be 2% change in EBIT. Extending this statement, as sales and contribution varies proportionately. We can say that for every 1% increase / decrease in sales there will be 2% increase / decrease in EBIT.
It is important to note here that it is risky to have a high operating leverage since a slight fall in sales will result in a disproportionately higher fall in profit.
3.2.2 Financial Leverage [FL] – Capital structure of a company plays a vital role in determining the return to the equity shareholders. Financial leverage is an indicator of impact of capital structure on the returns to the shareholders. Kohler defines financial Leverage as “the tendency of residual net income to vary disproportionately with net income”. The concept of financial leverage is very similar to that of Operating leverage in respect to fixed charge. In operating leverage we saw that fixed expenses result in disproportionate rise or fall in EBIT as compared to sales, in FL the same criterion applies about fixed interest which results into disproportionate rise or fall in Earnings Before Tax (EBT).
Continuing with the illustration given above (Company A ltd ) let us assume that the company pays fixed interest of Rs 500 p.m, then the profit will be as follows
Rs.
March April
Sales (No of units * selling price) 5,000 10,000
Less :
Variable costs – Materials 3,000 6,000
Contribution 2,000 4,000
Less :
Fixed costs – rent 1,000 1,000
EBIT 1,000 3,000
Less :
Interest 600 600
Earnings before tax; after interest 400 2,400
It is clearly evident from above solution that EBIT as percentage sales has gone up from 20% to 30%, whereas EBT as percentage of sales has gone up from 8% to 24%.
Operating leverage = EBIT = % Change in EBT
EBT % Change in EBIT
In current problem = % change in EBT is 500% (I.e Rs 400 to Rs 2400 ) and % change in EBT is 200% (i.e Rs 1000 to Rs 3000) = 500% / 200% = 2.5
Excessive financial leverage is always considered as very risky for any company. As when company is in profits it gives very good results but in case of losses it can be hazardous and may put company’s existence at stake.
3.2.3 Combined Leverage [CL] – As the name suggests combined leverage is simply combined effect of both operating leverage and financial leverage. It can simply be calculated as
-Combined leverage = Operating leverage * financial leverage = contribution EBT
The ratio of contribution to earnings before tax shows the combined effect of financial and operating leverage. A high operating and high financial leverage is considered to be very risky. If these leverages are very high then at a high level of production and selling company will earn high profits but a slight fall in sales will result in tremendous losses. A company must therefore maintain a proper balance
between these two leverages. Let us consider various leverage situations and its implications –
Operating
leverage Financial Leverag e
Implications
Low Low It indicates that management is too conservative and is not willing to take risk. Though the company is in a low risk situation, it is losing on opportunities to earn higher income.
High Low It can be considered as an ideal mix. Management is willing to take some risk on operations to earn higher profits, but is not taking undue risk on financial leverage. Low High This situation can be more profitable than the above
situation. As operating leverage is low, the company reaches its breakeven earlier
High High It is very risky situation and though it will give exceptional returns when company is in profits, in case falling sales losses will be tremendous.
3.3 Solved problems Problem 3.3.1 A Ltd. B Ltd. Sales 500 1,000 Less : Variable costs 200 300 Contribution 300 700 Less : Fixed costs 150 400 EBIT 150 300 Less : Interest 50 100
Please Calculate Operating, Financial and combined leverages and comment on the same
Solution –
Operating leverage (OL) = Contribution / EBIT
For A Ltd = Rs 300 lakhs / Rs 150 lakhs = 2 For B Ltd = Rs 700 lakhs / Rs 300 lakhs = 2.33 Financial Leverage (FL) = EBIT / PBT
For A Ltd. = Rs 150 lakhs / Rs 100 lakhs = 1.5 For B Ltd. = Rs 300 lakhs / Rs 200 lakhs = 1.5 Combined Leverage (CL) = Contribution / PBT = OL * FL
For A Ltd. = Rs 300 lakhs / Rs 100 lakhs = 3 For B Ltd. = Rs 700 lakhs / Rs 200 lakhs = 3.5 Comments –
e. Operating leverage – it is higher for B ltd. than for A ltd. That means management B ltd is taking more business risk.
ii. Financial leverage – Financial leverage for both the companies have the same degree of financial risk. It means that both the managements have similar perceptions about financial risks
iii. Combined leverage – B ltd has combined leverage more than A ltd. i.e B ltd is riskier but profitable than A ltd.
Problem 3.3.2
Calculate degree of operating, Financial and combined leverage for the following firms –
Firm A Firm B
Output (Units) 6,000 1,500
Fixed costs (Rs) 700 1,400
Variable cost per unit (Rs) 0.20 1.50
Interest on borrowed funds (Rs) 400 800
Selling price per unit (Rs) 0.60 5.00
Solution –
Firm A Firm B
Less : Variable costs 1,200 2,250 Contribution 2,400 5,250 Less: Fixed costs 700 1,400 EBIT 1,700 3,850 Less : Interest 400 800
Profit before tax 1,300 3,050
Operating leverage = Contribution / EBIT 1.41 1.36
Financial leverage = EBIT / PBT 1.31 1.26
Combined leverage = Contribution / PBT 1.85 1.72
Problem 3.3.2
A simplified income statement of Zenith Ltd. is given below. Calculate and interpret its degree of operating leverage, Financial leverage and combined leverage.
Income statement for the year ending 31st March 1998
Rs Sales 10,50,000 Variable costs 7,67,000 Fixed costs 75,000 EBIT 2,08,000 Interest 1,10,000 Taxes 29,400 Net income 68,600
(CWA final, June 1998) Solution –
i. Contribution = Sales – Variable cost = Rs. 10,50,000 – 7,67,000 = Rs. 2,83,000 ii. Earnings before interest and taxes (EBIT) = contribution – fixed costs = 2,83,000
– 75,000 = Rs.2,08,000
iii. Earnings before tax (EBT) = EBIT – Interest = Rs 2,08,000 – 1,10,000 = Rs 98,000
iv. Operating leverage = Contribution / EBIT = 2,83,000 / 2,08,000 = 1.36
The above ratio indicates that for every 1% change in sales it is expected that EBIT will change by 1.36%
V. Financial leverage = EBIT / EBT = 2,08,000 / 98,000 = 2.12
The above ratio indicates that for every 1% change in EBIT it is expected that EBT will change by 2.12%
vi. Combined leverage = Operating leverage * financial leverage = 1.36 * 2.12 = 2.88
The above ratio indicates that for every 1% change in sales it is expected that EBT will change by 2.88%
Problem 3.3.3
A firm has sales of Rs 2,00,000, variable cost of Rs 1,40,000, fixed cost of Rs 30,000 and interest of Rs 10,000. Calculate the leverages and ascertain the amount of sales required to double its Earnings before interest tax (EBIT).
Solution – Rs. Sales 2,00,000 Less : Variable cost 1,40,000 Contribution 60,000 Less : Fixed costs 30,000 EBIT 30,000 Less: Interest 10,000
Profit before tax 20,000
Operating Leverage = Contribution / EBIT = 6,00,000 / 3,00,000 = 2 Financial leverage = EBIT / EBT = 3,00,000 / 2,00,000 = 1.5
Combined leverage = Operating leverage * Financial leverage = 2 * 1.5 = 3
Operating leverage indicates that for every 1% change in sales there will be 2% change in EBIT.
Hence, for EBIT to get doubled i.e increase of 100%, sales should increase by (100/2)% = 50% . This can be elaborated as follows –
Rs. Sales (increased by 50%) 3,00,000 Less : Variable cost 2,10,000 Contribution 90,000 Less : Fixed costs 30,000 EBIT 60,000 3.3.4 Problem
From the following prepare income statement of A,B and C
Firm A Firm B Firm C
Financial Leverage 3 4 2
Interest Rs 200 300 1,000
Operating leverage 4 5 3
Variable cost as a % sales 66.67% 75% 50%
Income tax 45% 45% 45%
(CA final, Nov 97) Solution –
Firm A
Financial leverage = EBIT / EBT = 3 i.e EBIT = 3 EBT Again EBIT – interest = EBT
Therefore 3 EBT – Interest = EBT
Considering both the equations 3EBT – 200 = EBT ; 2EBT = 200 i.e. EBT = 100 and EBIT = 3*100 = 300
Now operating leverage = 4 = Contribution / EBIT = contribution / 300 Therefore Contribution = 4*300 = 1,200
As variable cost is 66.67% of sales that means contribution is 33.33% of sales or sales is 3 times the contribution i.e. sales = 3*1200 = 3,600
Firm B
Again EBIT – interest = EBT Therefore 4 EBT – Interest = EBT
Considering both the equations 4EBT – 300 = EBT ; 3EBT = 300 i.e. EBT = 100 and EBIT = 4*100 = 400
Now operating leverage = 5 = Contribution / EBIT = contribution / 400 Therefore Contribution = 5*400 = 2,000
As variable cost is 75% of sales that means contribution is 25% of sales or sales is 4 times the contribution i.e. sales = 4*2,000 = 8,000
Firm C
Financial leverage = EBIT / EBT = 2 i.e EBIT = 2 EBT Again EBIT – interest = EBT
Therefore 2 EBT – Interest = EBT
Considering both the equations 2EBT – 1,000 = EBT ; EBT = 1,000 i.e. EBT = 1,000 and EBIT = 2*1,000 = 2,000
Now operating leverage = 3 = Contribution / EBIT = contribution / 2,000 Therefore Contribution = 3*2,000 = 6,000
As variable cost is 50% of sales that means contribution is 50% of sales or sales is 2 times the contribution i.e. sales = 2*6,000 = 12,000
Income statement of Firms A,B and C can be drawn as follows –
Firm A Firm B Firm C
Sales 3,600 8,000 12,000
Less : Variable cost 2,400 6,000 6,000
Contribution 1,200 2,000 6,000
Less : Fixed cost 900 1,600 4,000
EBIT 300 400 2,000
Less : interest 200 300 1,000
EBT 100 100 1,000
Profit after tax 55 55 550
3.4 Cost - Volume - profit analysis
The analytical tools and techniques available to finance managers for studying the behaviour of profit in relation to changes in volume, cost and prices is known as the “Cost-Volume-Profit (CVP) analysis”. It is a tool used to determine the minimum quantity of sales for avoiding the losses and the quantity of sales at which the desired profit can be achieved. CVP analysis can be used to predict and evaluate the implications of its short run decisions about fixed costs, variable costs, sales volume and selling price for its profit plans on a continuous basis. Thus CVP technique seeks to establish –
a. The minimum amount of sales to avoid losses b. The level of sales to earn the targeted profit
c. The effect of change in prices, costs and volumes on profits d. The effect on profits of various sales mix.
e. The breakeven in terms of value and units under different conditions
3.4.1 Break-even point – The technique of calculation of breakeven point is used to calculate the quantity or amount of sales required to at least recover all the costs i.e a no profit no loss situation. Each unit sold covers up the whole variable cost and a part of fixed cost. The amount left over above the variable cost is termed as contribution per unit. Break-even point is the quantity of sales where the total contribution equals the total fixed cost.
Break-even point (in units) = Total fixed cost / contribution per unit Contribution per unit = Sales price per unit – variable cost per unit
Illustration 1 – Company x manufactures watches and has a capacity of 1,000 watches per year. Selling price per watch is Rs 2,500 and its variable cost per watch is Rs 1,500. The company has fixed costs to the extent of Rs 2,00,000. Calculate the company’s break-even point
Solution –
Rs.
Selling price per unit 2,500
Less : Variable cost 1,500
Contribution per unit 1,000
Break even point = fixed cost / contribution per unit = 2,00,000 / 1,000 = 200 watches
Thus the company must sell at least 200 watches per year to avoid losses. These can be elaborated as follows –
Sales (200 watches sold) Rs 5,00,000
Variable cost 3,00,000
Contribution 2,00,000
Fixed cost 2,00,000
Net profit / loss Nil
Illustration 2 – Consider the above problem and calculate the quantity of watches company x must sell to achieve desired profitability of Rs 4,00,000
Solution –
Quantity to be sold = (Fixed costs + desired profit) / contribution per unit = (2,00,000 + 4,00,000) / 1,000
= 600 units
Thus the company must sell at least 600 watches per year to earn desired profits. These can be elaborated as follows –
Sales (600 watches sold) Rs 15,00,000
Variable cost 9,00,000
Contribution 6,00,000
Fixed cost 2,00,000
Net profit 4,00,000
3.4.2 Limitations of break-even analysis – Though a very effective pricing and control tool break-even analysis has its own limitations. The basic assumption about the selling price and cost is practically difficult to achieve. It is highly impossible that contribution varies with the sales price, as with increased volumes sales price generally goes down, which may or may not result into proportionate decrease in costs. Cost is influenced by several factors including the production process, plant and machinery needed, raw material used, wages paid etc. which are sure to vary with higher scale of production and may lead to wrong break-even analysis.