Short notes on the sources of fund and financial management

Short notes on the sources of fund and financial management

Under the stock invest Scheme prepared by various banks, the investor can open an account for a deposit with the concerned bank and request the bank in writing to issue the instrument called BUSINESS RISK AND FINANCIAL RISK: business risk ( sometimes also referred to as operating risk) refers to the variability of earning before interest and taxes (FBTT) as a result of environment in which a company operates. The environment consists of company internal factors, industry speeific factors and economy specific factors, internal and external. The earning before interest and taxes of a firm are thus subject to many influences. These Influences may be peculiar to the firm, some are common to all the firms in the industry and some are related to the general economic conditions that affect all the firms in an uncertain world, EBIT in any period can out to be higher or lower than expected. Thus uncertainly with respect to EBIT often is referred to as business risk. Every business is subject to this risk. One major source of business risk is business cycle-the periods of business boom and recession. Other sources of business risk are technological changes obsolescence, government policies, actions of compertitor, shift in consumer preferences, changes in prices. Other unknown events and happenings,etc. The incidence of business risk is, therefore, unavoidable and not within the control of the firm. The degree of operating leverage measured by the formula.

Contribution____ is an index of business risk
Operting profit(EBIT)

Business risk is only a part of the total risk carried by the business. Other part of the risk is known as financial risk. Financial risk is related with the financing decisions or capital mix of a business. Two businesses exposed to the same degree of business risk can differ in respect of financial risk when they adopt different forms of financing. Financial risk is an avoidable and controllable risk because it is associated with a capital structure decision of the firm. For example
If a business were to decide not use debt capital structure, it will not have any financial risk . The presence of debt in the capital structure implies debt service obligation for the firm and thereby constitutes this types of risk. The extent of financial risk can be measured by computing debt-equity or interest coverage ratio and financial leverage ratio. Often , the degree of financial leverage measured by the formula.

Operating profit_(EBIT) is used as an index of financial risk.
Earning before tax(EBIT)



Dow jones’ theory: Dow jones’ theory deals with the behaviour of share prices in the market. According to dow jones theory , the movements in the share prices on the share market can be classified into the following three major categories:-


(a) The primary movements
(b) The secondary movements
(c) The daily fluctuations.

The primary movements reflect the trend of the share market and may continue from one to three years or even more. If one observes the long range behavior of share prices in the market, It may be seen that for sometime a definite consistent phase,
The secondary movements refer to the intervening movement movements in prices which last for a short period say three weeks to several months but, running counter to the primary trend. The secondary movements are supposed generally to retrace from one-third of the previous advance in a bull market or previous fall in the bear market.

The daily movements refer to every day’s irregular fluctuations in share price in either direction. These fluctuations are the result of the activities of speculators. An investor, really is not interested in such fluctuations and, therefore, he should keep himself away from them.

The understanding of Dow jones theory proves useful for an investor. The theory helps him in closing the time for investment in shares. According to this theory, investment should be made in shares when their prices have reached the lowest level and sell them at a time when they reached the highest peak in practice. It may be difficult to identify these points or trends. The Dow Jones theory in its pure form retains few followers today because it has generally failed to be leading indicator of future stock prices and it has not enable led the investors to achieve superior investment performance.
Stock invest: this is a new strument to be used in applying for shares of companies. stock invest) containing the statement that is guaranteed for payment at par on all braches. Simultaneously the bank will mark a LIEN on the investors Deposit Account to the extent of the Stock invest issued the investor while applying for the public issue will enclose the Stock invest forms duly filled in along with share application form and sent them to the collecting bank as he normally does under t6he existing system.
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Stock invest is not an alternative but an additional facility available to the investor in cash he so opts. The issuing company on the basis of the allotment to the applicant would encase the Stock invest instrument in respect of those applicants who are successful allottees, the unsuccessful applicants instrument s (Stock, invests) would be returned to them without encashing the scheme aimed at avoiding blocking of funds of the investors and any complamants from them about non - refund/delay
in refund of share application money. The major advantage of stockinvest is that the investor keeps on getting interest on his money during the interim
period.

Working capital cycle : This referm to the length of time between the firm's paying cash for materials, ( creditors) (entering into the prodiction process/stock),
and the inflow of cash from debtors ( sales). When costs are incurred on labour, overheads and raw materials, work-in progrees (WIP) is generated. In the production cycle, WIP is converted into finished goods. The finished goods when sold on credit, gets converted into sundry debtors. The debtors are realised after the credit period.This cash is then again used to pay for raw materials etc. Thus there is a complete cycle from cash to cash.

Short-term funds are required to meet the requirement of money during this period. The time period is dependent upon the length of time within which the original
cash gets converted into cash again. This cycle is also known as " operating cycle " and can be depicted as follows.


Pricing of rights share: Provisions of section 81 (1) of the compenies Act, 1956 are applicable in cash of issue of Rights Share. The letter of offer of Right issue has to be vatted by SEBI. The determination of price of Right Share means the price at which the right share are to be issued. In other words, it requires the determination of the amount of premium at which right share are to be issued. This premium is determined taking into account the intrinsic worth of the share, the future profit earning capacity of the company and the existing market quotation of the share, if it listed on the stock exchange. The price of rights share has to be determined keeping in view the following two objectives.

(a) The company would like that the issue is fully subscribed by its existing shareholders. For this purpose, it will have to keep the price at a level lower than the existing price being quoted on the stock exchange. For example, if the share is quoted at Rs. 16 at the stock exchange against its face value of Rs. 10, it is obvious that the right share cannot be issued at a premium of more than Rs. 6 Actually, it has to be issuedat a lower premium so that the existing shareholders are motivated to subscribe to it. The spread between the market price and the subscription price is of great importance. When the right shares are issued the upper limit of the premium is provided by the market price of that issue. The premium has to be fixed keeping in viewthe normal fall in the market price of a share when a right issue is announced.
If the difference between the market price and the issue price of right share is low, a situatian may arise when due to fluctuations in the market, the price of the share may fall below the price at which the right shares are offered. In such a situation the rights issue will not be successful since the existing shareholder will prefer to buy the shares from the market. Many companies have come to great due to issuing right share in a falling market.

(b) The state of capital market and the trends there in are of main importance in determining the premium. The price of right share must be kept at a level that it absorbs the drop in the market price of the shares arising out of the declaration of the right issue. the normal fluctuations and the drop in the price due to the fact that the number of shares would now be larger than earlier. It must be realised that issue of rights share must take into account the expectationsof investors regarding the future outlook of the companv.

In conclusion the pricing of rights share should be such as the shareholders get an advantage even after the ditution of market price of the shares. If the price of the rights share becomes negative due to dilution in the market price of share, it is obvious that the shareholders will not subscribe to such shares.

Swaps is one of the new instruments in international capital market. It is the cost of exchanging one currency into another for a specified of time. The swap will represent an increase in the value of the forward exchange rato (a premium) of a decrease (discount). Swap has mainly two main categories, viz, interest rate swaps and currency swaps or combination of both.

In the interest swaps category, a fixed rate ot interest is swapped for a floating rate of interest or vice-versa. Here two parties agree to exchange the interestpayment on a national principal over a specified period without exchange of principal amount. Currency swaps allows an equity to redenominate a ioan from one currency into another currency. Here, both principal and interest in one currency are swapped for principal and interest in another currency.

Hedging on the other hand, is a transaction that limits the risk associated with market price fluctuation of securities The hedge means to take opposite positions in the cash market and the futures market. Hedges are undertaken to reduce the risk of adverse price movement.
Short hedges are used to protect against unexpected increasos in interest rates. A short hedge is formed when a long position in the cash is hedged by going short in the futures market. Long market hedges are used to protect against falling interest rates. A long hedge is formed when a short position in the cash market is hedged by going long in the future market.

Diversification vs. Divestment strategies

Diversification strategy is defined as a strategy in which growth objectives of a corporate unit are sought to be achieved by adding new product or service to the existing proruct line. According to steiner, diversification is producing new product for market involving quite different skilld, processes and knowlodge from those associated with current products and services or markets. Thus in diversification novel products are acquired and previously unexplored market are entered. During past two decades, business organisations have been pursuing diversification strategy for accomplishing greater growth and stability.

On the other hand, divestment strategy involves selling off or liquidating unprofitable business units or product divisions or sequence of business operations with negative cash flows. In divestment strategy, the organisation decides to get out of certain business and sell units or divisions. The basic objective underlying a divestment strategy is to prevent any particular unit or segment of business being a drag on the total profitability of the enterprise, particularly when opportunities of alternative investment exist.

Technical appraisal of projects

Viability test of project is to be carried out by examining the project from different aspects, one of them being technical espect of project appraisal. Technical examination of a project involves consideration of the following factors:

1. Feasibility of the selected technical process and its suitability under Indian conditions.
2. Scale of operations.
3. Location.
4. Plant and equipment and their specifications.
5. Plant layout.
6. Facilities for the supply of water, power and fuel.
7. Facilities for disposal of waste and also of the by-product, if any.
8. Availability for economies of the means of transport in the region be examined and ensured.
9. Arrangement for Raw materials and lobour.
10. Constrution schedule.
11. Cost estimates, including provision of operative expenses machinery spare-parts, working capital etc.

Financial feasibility study of new projects : when a new project is ventured upen, feasibility of it from different angles such as technical commercial and financial is studied both by the promoters and by lending financial mstitutions of these angles, financial feasibility is the most important as there can be no compromise as to this aspect of viability.

The important issues examined as part of financial feasibility study are:

1) Eastimates of the cost of the project.

2) Pattern of financing.

3) Profitability and cash flows.

4) Internal rate of return.

5) Debt service capacity.

Financial institutions, when they evaluate feasibility, are likely ti strees on debt service capability besides an assessment of managerial capability. From the angle of promoters, the emphasis is likely to be on the internal rate of return vis-a-vis the cost of capital.

Bridge finance: Bridge finance refers, normally, to loans taken by a business, usually from commercial banks for a short period, pending dusbursement of term loans by financial institutions. Normally ,it takes time for the financial institution to finalise procedures of creation of socurity, tie-up participation with other institution etc, even though a positive appraisal of the project has been made. However, once the loans are approved in priciple, firms in order not to lose further time in starting their projects, arrange for bridge finance. Such temporary loan is normally repaid out of the proceeds of the principal term loans. Generallythe rate of interest on bridge finance is 1% or 2% higher than on normal term loans.

Traditional theory of cost of capital : There are broadly, two approaches to determine the capital structure in relation to cost of capital. The older approach is referred to as the traditional theory and the later, called after the names of its propounders, the Miller-Modigliani Thepry.

Traditional theorists argue:

(a) that debt is cheaper than equity becouse of the tax shield on interest;
(b) that. therrfore, if debt is increased and equity part decreased, average cost of capital will be reduced.
(c) that, however, if debt is increased beyond certain leveles, investors will start perceiving greater degree of risk which in turn , will increase expectations and cost of capital ; and
(d) that, in the light of the above ,a solution to the capital structure problem will be in optimising debt vis-a-vis least rate for average cost of capital.
Thus, a firm should strive to reachthe optimal capital structure and increase its total valuation through a judicious use of loan capital.

Common Size statements : One useful way of analysing financial statements is to convert them into common size statements by expressing absolute rupee amounts into percentage. In case of the income statements, all items of expense are exhibited in percentage of sales. Sales are taken at 100%. Similarly in balance sheet individual asset and liability is shown as a percentage of total Assets/Liabilities.

Common size statements preppared for a firm/company over the years would highlight the relative changes in each group of expenses, assets and liabilities. These statements are very useful in inter-firm comparisons.

An illustration of common size statement regarding the profit and loss statement of X Ltd. is given below:

Profit and loss statement

Net sales 100%
Cost of goods sold 50% / 50%
Gross profit
Selling, administration
and general expenses 25% / 25%
PBIT
Interest 10% / 15%
PBT
Tax PAT
concentration Banking is one of the methods for speeding up the process of collecting recievables. This helps in reducing the size of the float. Inthis metnod, a number of strategic collection centres in different regions are established instead of a single collection point. The system reduces the time period between the time a customer mails his remittances and the time when the funds became available for spending with the company.Payment recieved by the different collection centres are concentration bank of the head office. The bank with which the company has its major abnk account its normally located at the head office.


Factoring refer to the buying of trade receivables. One who buys trade receivables is called 'factor'. The following are the benefits of factoring:
i). Factoring eliminate the need for cash discounts.
ii). Suppliers of goods and services can concentrate on their making activies without worry for collection of receievables.
iii). Due to specialization , a factor can effect prompt and timely payment’s.
iv). The dealer is saved of the cost of carrying debtors and maintaining collection department . It increase his return.
v). Factoring improves the liquidity of a firm.


One of the method of comparing two alternative proposals of capital expenditure is desirability factor or usually known as ‘ profitability index’. It is more relevant when we have to compare number of proposals each involving different amount of cash flows. Desirability factor is calculated as follows:


Sum of discounted net cash inflows
Initial cash outlay

Suppose we have three projects X,Y,Z, each involving an outlay of Rs 50,000 Rs 75,000 and 100,000 respectively. Further, the sum of the discounted cash inflows from projects are Rs 60,000 ,Rs 95,000 and 1,25,000 resectively.The desirability factors of these projects come to 1,2,1.267 and 1.25 respectively.In terms of absolute NPV, project Z has the highest NPV of Rs 25,000 whereas in terms of desirability factor, project Y which shows the highest profitability index, should be preferred. Thus desirability factor helps in ranking various projects, particularly when a situation of capital rationing prevails.


It is a short term unsecured promissory note sold by large business firm to arrange cash. These are sold either directly or through dealers companies with high credit rating can sell commercial papers was recommended by a working group on the money market, appointed by the Reserve Bank of India in 1986.

The main conditions for issues of commercial paper are :
i). The working capital (fund based) limit of a company should not be less than Rs 10 crores.
ii). The denomination could be in multiples of Rs 5 lakhs subject to a minimum investment by a single investor of Rs 25lakhs (par value).
iii). Aggregate amount to be raised by issue of commercial paper should not exceed 30% of the company’s working capital limit.
iv). The currency of the instrument is 3-6 months.
v). Credit rating of the company issuing commercial paper should not be below 3% by CRISIL.

Financial forecasting techniques: Forecating is the starting point in a planing process. The success of forecasting lies in the degree of accurany as well as the simplicity of the forecasting techniques. Now a day with the use of computers, highly sophisticated techniques can also be employed in financial forecasting. A new forecating techniqhes are briefly considered below.

(a) Precent of sales method : The simplest forecasting can be made by estimating the financial needs on a sides forecast . Any change in sales is likely to have an impact on various items of assets and liabilities. Hence , these items are expressed for changes in levels of activity . A sound knowledge of the relation between sales and assets is a prerequisite to the use of the method. This method is more suitable for short term forecasting.

(b) Simple regression method : With sales forecast as the starting point and based on the past relationship between sales and assets items, it is possible to construct a line of best fit or the regression line. It is possible to link sales with one it em of asset as a time. This method is more suitable for long term forecasting.

Zero coupon Bouns: These are bonds issued at a deep discount to their face value. their redemption will be at par on \\\\\\\\\\ and no interest coupon in between is admissible. The initial discount is so calculated to give a yield to maturity consistent with prevalling market alternatives. Zero coupon bonds are genarally issued to arbitrage tax barrier. In addition investors in zero coupon bonds have a view that interest rates are on a declining trend hence by buying zero coupon they buy instrument which not only lock in current market yields but also take into account the reinvestment of interest ////////// back at the current yield . These bonds are also known as pure discount bonds.

SEBI : The securities and Exchange Board of India (SEBI) is the nodel agency formed under an Act of Parliament i.e. (SEBI Act), 1992.The Act, is extended to whole of India and has come into force on 30th January, 1992. SEBI is entrusted with the task of regulating capital market and related issues in India. This has been established after the repeal of the Capital Issues Control Act, 1947.

SEBI has formulated a basic set of guidelines for disclosure and Investor Protection in 1992. These guildlines form the core of SEBI's regulation and cover various aspects such as pricing , promoter's contribution' look-in period ,credit rating etc.

SEBI had also taken steps for registration of all intermediaries in the captial market, prescring their code of conduct and enforcing market discipline etc.
Euro Issues : The Government of India, as a part of liberalistion and de-regulation of industry and to augment the financial resource of companies, has allowed companiesto directly tap foreign resouces for thier reguirements. The liberalised measures have boosted the confidence of foreign investors and provided an opporrunity to india-conpaniws to explose the possibility of tapping the International Captical Market for their financial requirements, where the resources are raised through the mechanism of Global Depository Receipts(GDRs0, A deposity receipt is basically a negotiable certificate, denominated in USdollars, that represents a non-US company's pubicly traded local currency(Indian rupee) equity shares. The depository receipt can also represent a debt instrument During the first half of the fiscal year 1994-95. Indian companies moblilsed more than $ 1 billion through GDR and Euro-convertible bond issues.

The guidelines for Euro-issues-1994-95 were announced by the government on May 11, 1994 However, the Finance Ministry has reviewed recently the guidelines
applicable to Euro -issues. The major features of Euro-issues are.

(1) The issue is in foreign currency.
(2) The issue is to investors outside India.
(3) It is under////////////////////////// and traded in by international syndicate of bank/financial institions.
The reasons for sudden spurt in such issues are:
(1) European market are flushed with funds.
(2) Euro investors are looking for higher yield than that available locally.
(3) Opening up of the Indian economy.

Venture capital

Venture capital may be for financing which is specially designed for high risk and high reward projects. It is direct investment in securities of new and new enterprises by way of private placement. It plays an important role not only in financing high technology projects but also helps to turn research and development into commercial production. Venture capital is also involved in fostering growth and development.

In India, venture capital scheme is of recent origin. In recent years, the moves to deregulate both industries and financial market, coupled with the country's defective infrastructure and strong domestic market have made this country ideal for formation of venture capital industry as a provider of development and risk capital prior of listing. Presently, in India, there are about 15 venture capital funds operating and have been promoted by both the private and public sector.

Systematic and Unsystematic Risk

Systematic risk is that part of total risk that results from the tendency of stock prices to move together with the general market. Some of the examples of systematic risk include market risk interest rate risk and purchasing power risk, etc. On the other hand, unsystematic risk is that portion of a security risk which emerges as a result of known and controllable factor. Some of the major, examples of unsystematic risk, include business risk, financial risk, default and insolvency risk and other risks. The basic distinction between two is that unsystematic risk is diversifiable and can be eliminated by increasing the number systematic risk is non-diversifiable and cannot be eliminated.

Indicators of social desirability of a project : In the context of project evaluation. It is not sufficientthat a project should only be commercially viable but it should also be socially desirable. The following are the indicators of social desirability of a project:

(1) Employment potential criterion : Projects which have higher employment potential are naturally preferred, particularly in developing countries.

(2) capital output ratio : This ratio shows the value of expected output in relation to the capital employed. Under this criterion, a project which gives a high output
per unit of capital is ranked high.

(3) value added per unit of capital of capital : In this, instead of taking the value of output, value added by the project is cansidered. It shows the net contribution of
a project to the national economy, hence a good indicator for ranking projects according to their economic importance.

(4) Foreign exchange benefit criterion : This seeks to evaluate the likely of a project on the overall balance of payments of the country. Project which promise to
earn more of foreign exchange are given preference.

(5) Cost benefit ratio criterion : This criterion attempts to measure the total effect of all the social benefits and costs of a project.

Marginal cost of capital : It is the cost of raising an additional rupee of capital. It is derived when the average cost of capital is computed with marginal weights. The weights represent the proportion of funds the firm intends to employ. The marginal cost of capitalis calculated with the intended financing proportion as weights. When the funds are raised in the same proportion and if the component costs remain unchanged, there will be no difference between average cost of capital and marginal cost of capital. The component costs may remain constant upto a certain level and then start increasing. In that case both the average cost and marginal cost will increase but the marginal cost of capital will rise at a faster rate.

Use of ratios for predicting sickness: A good deal of research has been done in using ratios for predicting sickness of an enterprise. Two types of studies viz, univariate and multi variate help in predicting. The former uses individual ratios whereas the latter encompasses several ratios. Studies have been conducted in India and abroad and the following ratios are used in prediction by the formulation of a model.

Cash flow to total debt, net income to total assets, total debt to total assets, working capital to total assets and current assets to current liabilities . These ratios were selected by Beaver.

Altman developed an empirical model using multiple discriminate analysis. His model was
Z = Overall index of the multiple discriminant function.
X1 = Working capital/Total Assets
X2 = Retained Earning/ Total Assets
X3 = EBIT/Total Assets
X4 = Market Value of Equity/ Book Value of Total liabilities
X5 = Sales/Total Assets

Depending on the value of Z, it was possible to predict the sickness. If Z score comes to more than 2.99 there is no danger of bankrupty, Z score below 1.81 indicates imminent insolvency and Z score between 1.81 and 2.99 shows the grey area. Similar models have been developed by other also.

Under capitalisation : It is a state where in a company does not have sufficient funds at its disposal to carry on its activities. The company may not have adequate arrangement for meeting its working capital requirement . This may also happen when some fixed assets acquired on lease are depleted. In an under- capitalised company, the current ratio will be low, hence liquidity is in danger. Profitability will be eroded and essential expenditure like repairs, maintenance, advertising, research and development also cannot be incurred. Under this situation, purchases cannot be made at a proper time and adequate inventories cannot be built up. The entire operating cycle is affected. Hence the company should take immediate steps for arrangement of funds to get rid of a situation of under capitalisation.

Bills discounting as a means of finance : Bill discounting is a short term source of finance. It can be either supplier bill (erchase ) or for sale of goods. These can be discouted with Financial Institutions, Bank and non-banking finance companies.The Reserve Bank of India and the Central government have been placing emphasis on developing bill discounting culture . Bill discounting fee is generally taken up-front. To the extent cost should be adjusted to compare with other means of financing. Additional cost like stamp duty ,bank charges should also be taken into account . However, there is scope for misuse in forms of accommodation bill. Through billl ,it is easierto colllect interest for delayed payments.