Working capital Management, techniques and Sources of Finance

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INDEX

Sr. No. Particulars Page No.

1. Introduction and Meaning 2-7

2. Working Capital Cycle 8-10

3. Types of Working Capital Strategies 11-12

4. Methods for estimating working capital requirement 13-18

5. Sources of Finance 19-33

6. Methods of Capital Investment Decision 34-38

7. Webliography 39

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INTRODUCTION AND MEANING:

What is 'Working Capital'

Working capital is a measure of both a company's efficiency and its short-term financial health.

Working capital is calculated as:

Working Capital = Current Assets - Current Liabilities

The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has

enough short term assets to cover its short-term debt. Anything below 1 indicates negative W/C

(working capital). While anything over 2 means that the company is not investing excess assets.

Most believe that a ratio between 1.2 and 2.0 is sufficient. Also, known as "net working capital".

If a company's current assets do not exceed its current liabilities, then it may run into trouble

paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining

working capital ratio over a longer time period could also be a red flag that warrants further

analysis. For example, it could be that the company's sales volumes are decreasing and, as a result,

its accounts receivables number continues to get smaller and smaller.Working capital also gives

investors an idea of the company's underlying operational efficiency. Money that is tied up in

inventory or money that customers still owe to the company cannot be used to pay off any of the

company's obligations. So, if a company is not operating in the most efficient manner (slow

collection), it will show up as an increase in the working capital. This can be seen by comparing

the working capital from one period to another; slow collection may signal an underlying problem

in the company's operations.

• If the ratio is less than one then they have negative working capital.

• A high working capital ratio isn't always a good thing, it could indicate that they have too

much inventory or they are not investing their excess cash

Working capital (abbreviated WC) is a financial metric which represents operating

liquidity available to a business, organization or other entity, including governmental entity.

Along with fixed assets such as plant and equipment, working capital is considered a part of

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operating capital. Gross working capital equals to current assets. Working capital is calculated

as current assets minus current liabilities.[1] If current assets are less than current liabilities,

an entity has a working capital deficiency, also called a working capital deficit.

A company can be endowed with assets and profitability but short of liquidity if its assets

cannot readily be converted into cash. Positive working capital is required to ensure that a firm

is able to continue its operations and that it has sufficient funds to satisfy both maturing short-

term debt and upcoming operational expenses. The management of working capital involves

managing inventories, accounts receivable and payable, and cash.

Working capital is the difference between the current assets and the current liabilities.

The basic calculation of the working capital is done on the basis of the gross current assets of

the firm.

Current assets and current liabilities include three accounts which are of special importance. These

accounts represent the areas of the business where managers have the most direct impact:

• Accounts receivable (current asset)

• Inventory (current assets), and

• Accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-

term claim to current assets and is often secured by long-term assets. Common types of short-term

debt are bank loans and lines of credit.

An increase in net working capital indicates that the business has either increased current

assets (that it has increased its receivables, or other current assets) or has decreased current

liabilities—for example has paid off some short-term creditors, or a combination of both.

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Working capital is that amount of funds which is required to carry out the day-to-day operations

of an enterprise-whether big or small. It may also be regarded as that portion of an enterprise’s

total capital which is employed in its short-term operations.

These operations consist of primarily such items as raw materials, semi-processed goods, sundry

debtors, finished products, short-term investments, etc. Thus, working capital also refers to all the

short-term assets known as current assets used in day-to-day operations of an enterprise.

The Accounting Principles Board of the American Institute of Certified Public Accountants,

U.S.A. has defined working capital as follows:

“Working capital, sometimes called net working capital, is represented by the excess of current

assets over current liabilities and identifies the relatively liquid portion of total enterprise capital

which constitutes a margin of buffer for maturing obligations within the ordinary operating cycle

of the business.”

What is an Operating Cycle:

Working capital is also called a circulating capital or revolving capital. That is the money/capital

which circulates in various forms of current assets in a continued manner. For example, at a point

of time, funds may be tied up in raw materials, then later converted into semi-finished products,

then into finished/ final products and when these finished products are sold, it is converted either

into account receivables or cash.

This cash is reinvested in current assets. Thus, the amount always keeps on circulating or revolving

from cash to current assets and back again to cash. That is why some people prefer to use the term

liquidity management instead of working capital management. Although this circulation takes

place at short intervals, the money is required again and again.

The American Institute of Certified Public Accountants defined the operating cycle as: “the

average time intervening between the acquisition of material or services entering the process and

the final cash realisation.”

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According to I. M. Pandey, “Operating cycle is the time duration involved in the acquisition of

resources, conversion of raw materials into work- in-process into finished goods, conversion of

finished goods into sales and collection of sales.”

Thus, operating cycle of a manufacturing enterprise involves three phases:

1. Acquisition of resources such as raw material, labour, power and fuel etc.

2. Manufacture of the product which includes conversion of raw material into work-in-progress

into finished goods.

3. Sale of the product either for cash or on credit. Credit sales create account receivable for

collection.

The operating cycle or circulation flow of money can best be projected in the following manner:

Capital/finance is regarded as life-blood of any enterprise. Therefore, the significance of working

capital in an enterprise lies in the fact that its circulation has to be properly regulated in the

business. Because, any over-circulation or under-circulation may create problems just as improper

blood circulation called high or low blood pressure, in the human body may create problems.

It is also noteworthy that the total working capitals composed of two parts are known as (i) Regular

or Fixed and (ii) Variable. The amount which is needed, of course, at short intervals to invest again

and again in current assets is called Regular or Fixed Working Capital.

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In fact, this investment is irreducible minimum and remains permanently sunk in the enterprise.

The other part of the working capital may vary due to the fluctuations {i.e. Rise or fall) in the

volume of business. Hence, it is called as the ‘Variable Working Capital.’

The two parts of working capital are shown in the Figure 25.2.

Figure 25.2 clearly illustrates the difference between fixed and variable working capital. However,

the fixed working capital line need not be horizontal if the firm’s requirement for fixed working

capital is increasing or decreasing over the period.

For a growing enterprise, the difference between fixed and variable working capital can be

depicted through the following Figure 25.3.

What is Net Operating Cycle:

The net operating cycle, also called the cash conversion cycle, is the number of days it takes a

company to generate revenues with assets.

How it works (example):

Analysts can calculate the length of the cycle with the following formula:

Net Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding + Days Payables

Outstanding

Note that DPO is a negative number.

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The net operating cycle involves determining how long it takes to create inventory, sell inventory

and collect on invoices to customers. For example, let's say Company XYZ makes widgets, which

typically sit in the warehouse for 10 days. Let's also assume that it typically takes 15 days to collect

on the sale of each widget, and that it takes 14 days to pay invoices to Company XYZ's vendors.

Using the formula above, Company XYZ's net operating cycle is:

Net Operating Cycle = 10 + 15 + -14 = 11 days

This means that Company XYZ generates cash from its assets within 11 days.

Why it matters:

The net operating cycle is a measure of how long an investment is locked up in production before

turning into cash.

Changes in net operating cycle can be very telling. For example, when companies take a long time

to collect on outstanding bills, or they overproduce and fill up the warehouse because they can't

figure out what sells, their net operating cycles lengthen. For small businesses especially, long net

operating cycles can be the difference between profit and bankruptcy. After all, companies can

only pay for things with cash, not profits. In turn, the net operating cycle is a measure of managerial

competency as well as operational efficiency.

It is important to note that different industries have different capital requirements and standards,

and determining whether a company has a long or short net operating cycle should be made within

that context.

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WORKING CAPITAL CYCLE

Working Capital cycle (WCC) refers to the time taken by an organization to convert its net current

assets and current liabilities into cash. It reflects the ability and efficiency of the organization to

manage its short-term liquidity position.

In other words, the working capital cycle (calculated in days) is the time duration between buying

goods to manufacture products and generation of cash revenue on selling the products. The shorter

the working capital cycle, the faster the company is able to free up its cash stuck in working capital.

If the working capital cycle is too long, then the capital gets locked in the operational cycle without

earning any returns. Therefore, a business tries to shorten the working capital cycles to improve

the short-term liquidity condition and increase their business efficiency.

The working capital cycle focuses on management of 4 key elements viz. cash, receivables

(debtors), payables (creditors) and inventory (stock). A business needs to have complete control

over these four items in order to have a fairly controlled and efficient working capital cycle. Let

as look at an example to enable a better understanding of the concept of working capital cycle.

Every company would like to keep its working capital cycle as short as possible. A shorter working

capital cycle can be achieved by focusing on individual aspects of the working capital cycle. Let

us see how this works:

The company can aim to shorten its working capital cycle by:

• Reducing the credit period given to its customers and thereby reducing the average

collection period. Giving cash discount can also help improve the debtor’s turnover ratio

or average collection period amid various other ways.

• The company can try to improve/streamline its process of manufacturing and focus on

various ways to increase sales to reduce the time taken for inventory to convert to sales.

The earlier the stock clearance better is the working capital cycle.

• A better negotiation to increase the credit period from suppliers of raw material and goods

required for production can also aid reduction in the working capital cycle.

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While the average collection period and credit period from supplier’s aid in shortening the working

capital cycle, the initial prime focus of the business should be to reduce the time taken for inventory

to convert to sales. If the time taken is very long it could imply that the business is not able to

generate sales for the goods produced and more and more capital gets locked in inventory. Either

the business should try and reduce the time or should reduce the amount of inventory thereby

reducing the amount locked in working capital. In other words, if the business is not able to reduce

its working capital cycle and has higher inventory levels, it should aim at reducing inventory levels

and reduce the amount locked in the working capital keeping the cycle time length same.

Most businesses cannot finance the operating cycle (average collection period + inventory turnover

in days) with accounts payable financing alone. This shortfall can be managed by the business

either out of profits accumulated over time, borrowed funds or by both. Let us look at the sources

of funding which can be used to manage the gaps in working capital cycle.

Sources of Short-Term Working Capital Financing:

• Lines of Credit: The Company can borrow from banks for a short-term (usually 30 – 60

days) against a line of credit given by the bank. The same can be paid off once sales

proceeds are collected from debtors.

• Trade Credit: Often good relations with creditors can be used for extending credit period

as one of the cases in case of a large order and enable financing at a lower cost.

• Factoring: Factoring or discounting of receivables can shorten the working capital cycle

and generate cash however this is usually at a higher cost.

• Short Term Loans: Companies who may not be able to get a line of credit may look for the

short-term working capital loan from a bank.

• Having briefly known the sources of working capital financing, let us understand the nature

of the working capital cycle:

The nature or the length of the working capital cycle differs from business to business and varies

among sectors. Working capital cycle in a manufacturing company as seen above in the example

is usually positive as there is a time lag between the goods produced and goods sold (time is taken

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for inventory to convert to sales). However, there is a possibility of a negative working capital

cycle in specific businesses.

Negative Working Capital Cycle

Let us look at the business model of a super market or hyper market chain. The customers who

come to purchase pay by cash and hence there aren’t any debtors or the collection period is 0 days.

The business is a supermarket and hence, all items in the store are taken from vendors and have a

credit period availability to be paid. So usually such businesses enjoy the huge cash and even may

make interest earning on the cash till the money needs to be paid to the suppliers. Therefore, these

companies have a negative working capital cycle.

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TYPES OF WORKING CAPITAL STRATEGIES

These three working capital approaches are best explained with the help of the following graph

and equations. First, we need to understand the graph properly. The red horizontal lines represent

the lines of 3 strategies. The simple line is Conservative strategy, below that line with spaces, is

hedging strategy and below that dotted line is an aggressive strategy. These lines indicate the extent

of utilization of long-term sources. Higher the line, bigger is the investment through the long-term

source of finance.

For equations, we will use the following abbreviations:

FA= Fixed Assets

PWC = Permanent Working Capital

TWC = Temporary Working Capital

Hedging (maturity matching) strategy

This is a meticulous strategy of financing the working capital with moderate risk and profitability.

In this strategy, each of the assets would be financed by a debt instrument of almost the same

maturity. It means if the asset is maturing after 30 days, the payment of the debt which has financed

it will also have its due date of payment after almost 30 days. Hedging strategy works on the

cardinal principle of financing i.e. utilizing long-term sources for financing long-term assets i.e.

fixed assets and a part of permanent working capital and temporary working capital are financed

by short-term sources of finance. Here, funds are applied as below and can be clearly seen in the

above diagram.

Long Term Funds will Finance >> FA + PWC

Short Term Funds will Finance >> TWC

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Conservative strategy

As the name suggests, it is a conservative strategy of financing the working capital with low risk

and low profitability. In this strategy, apart from the fixed assets and permanent current assets, a

part of temporary working capital is also financed by long-term financing sources. It has the lowest

liquidity risk at the cost of higher interest outlay. Here, funds are applied as below and can be

clearly seen in the above diagram.

Long Term Funds will Finance >> FA + PWC + Part of TWC

Short Term Funds will Finance >> Remaining Part of TWC

Aggressive strategy

This strategy is the most aggressive strategy out of all the three. The complete focus of the strategy

is in profitability. It is a high-risk high profitability strategy. In this strategy, the dearer funds i.e.

long term funds are utilized only to finance fixed assets and a part of the permanent working

capital. Complete temporary working capital and a part of permanent working capital also are

financed by the short-term funds.

It saves the interest cost at the cost of high risk. Here, funds are applied as below and can be clearly

seen in the above diagram.

Long Term Funds will Finance >> FA + Part of PWC

Short Term Funds will Finance >> Remaining Part of PWC + TWC

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METHODS FOR ESTIMATING WORKING CAPITAL REQUIREMENT

There are broadly three methods of estimating or analyzing the requirement of working capital of

a company viz. Percentage of revenue or sales, regression analysis, and operating cycle method.

Estimating working capital means calculating future working capital. It should be as accurate as

possible because the planning of working capital would be based on these estimates and bank and

other financial institutes finance the working capital needs to be based on such estimates only.

Percentage of sales method:

In this method, level of working capital requirements is decided on the basis of past experience.

The past relationship between sales and working capital is taken as a base for determining the size

of working capital requirements for future. It is, however, presumed that relationship between sales

and working capital, as existed in the past, has been stable.

It is the easiest of the methods for calculating the working capital requirement of a company. This

method is based on the principle of ‘history repeats itself’. For estimating, a relationship of sales

and working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e.

Working capital level is 40% of sales, the next year estimation is done based on this estimate. If

the expected sales are 500 million dollars, 200 million dollars would be required as working

capital.

The advantage of this method is that it is very simple to understand and calculate also.

Disadvantage includes its assumption which is difficult to be true for many organizations. So,

where there is no linear relationship between the revenue and working capital, this method is not

useful. In new startup projects, also, this method is not applicable because there is no past.

Advantages and Disadvantages of Percentage of Sales Method

Advantages of this method are that it is easy to understand and simple to calculate. There is not

rocket science in calculating the working capital based on this method.

The biggest disadvantage is its assumption which is not very practical in all situations. This method

is useful only where the relation between the revenue and working capital is linear. Elsewhere this

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method is not suggested. Another drawback is that it is highly dependent on sales forecast. If the

sales forecast is faulty, a whole calculation will be faulty. Higher working capital would attract

higher interest cost and low profitability and lower working capital would pose a problem to the

smoothness of the operating cycle.

Percentage of sales method is simple and easily understood and is practically used for ascertaining short-

term changes in working capital in future. However, this method lacks reliability in as much as its basic

assumption of linear relationship between sales and working capital does not hold true in all the cases. As

such, this method cannot be recommended for universal application.

Regression analysis method:

This is a statistical method of determining working capital requirements by establishing the

average relationship between sales and working capital and its various components in the past

years. In this regard the method of least squares is employed and the relationship between sales

and working capital is expressed by the equation:

Y = a + bx …(35.1)

The values of ‘a’ and ‘b’ are obtained by the solution of simultaneous linear equations given as

under:

Y = na + bx

where a = fixed component

b = variable component

x = sales

y = inventory

n = number of observations

This statistical estimation tool is utilized by mass for various types of estimation. It tries to

establish trend relationship. We will use it for working capital estimation. This method expresses

the relationship between revenue & working capital in the form of an equation (Working Capital

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= Intercept + Slope * Revenue). The slope is the rate of change of working capital with one unit

change in revenue. Intercept is the point where regression line and working capital axis meets Will

not go deeper into statistical details). At the end of the statistical exercise with past revenue and

working capital data.

Advantages and Disadvantages

The advantage of this method is that it is based on the regression analysis which is a proven method

of forecasting. Bigger the amount of data we have, better are the chances of accuracy with this

method. Its drawback is that it is not simple like percentage of sales method. The understanding

and calculation, both are difficult and lengthy.

Y = na + bx

338 = 5A + 508b

71.76 771b = a + 107 66929

6.06929 = b + 416 771b

a = -2.167622

b = 0.68 66892

The relationship between Sales and Current assets can now be expressed as follows:

Y = a + bx

Where x = sales

Y = current assets

When Sales = Rs. 194

Working Capital Y = – 2.16 + (0.68)(194)

= -2.16 + 131.92

= Rs. 129.76 crore

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Operating cycle:

According to this approach, size of working capital requirements of a firm is determined by

multiplying the duration of the operating cycle by cost of operations.

The duration of the operating cycle may be found with the help of the following formula:

0 = R + W + F + A – P … (35.2)

Where O = Duration of Operating cycle

R = Duration of raw materials

F = Duration of work-in-process

A = Duration of accounts receivable

P = Duration of accounts payable

Duration of raw materials reflects the number of days for which raw materials remain in inventory

before they are issued for production.

The following formula can be

used to determine duration of Raw

materials:

Duration of the work-in-process denotes the number of days required in the work-in-process stage.

It may be ascertained with the help of the following formula:

Duration of finished goods refers to the number of days for which finished goods remain in

inventory before they are sold.

This can be computed by the following formula:

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Duration of the Accounts Receivable represents the number of days required to collect the accounts

receivable.

This may be calculated as under:

Duration of Accounts Payable refers to the number of days for which the suppliers of raw materials

offer credit.

This may be measured with the help of the following formula:

With the help of the following illustration we can explain how level of working capital requirement

can be calculated.

This is probably the best of the methods because it takes into account the actual business or

industry situation into consideration while giving an estimate of working capital. A general rule

can be stated in this method. Longer the working capital operating cycle, higher would be the

requirement of working capital and vice versa. We would agree to the point also. The following

formula can be used to estimate or calculate the working capital

Working Capital = Cost of Goods Sold (Estimated) * (No. Of Days of Operating Cycle / 365 Days)

+ Bank and Cash Balance.

Advantages and Disadvantages of Operating Cycle Method of Working Capital Calculations

The advantage is that it is a detailed method and based on the actual economic conditions

prevailing in the market. It gives a detailed understanding of the business as well and it is precise

compared to other methods. The disadvantage is that it is a lengthy process to arrive at a

component-wise calculation of working capital. It needs a lot of estimate like estimated production,

holding period of inventory, collection and payment period, etc. So, it is a risky matter. There are

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probable chances of going wrong in estimating these data and that may hurt the whole process. It

is advisable to keep a cushion while estimating things on the darker side.

Manufacturing expenses are expected to occur evenly. The work-in-process state lasts for one

month. Hence, on average the manufacturing expenses component in work-in-process value will

be equal to half month’s manufacturing expenses.

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SOURCES OF FINANCE

There are various sources of finance such as equity, debt, debentures, retained earnings, term loans,

working capital loans, letter of credit, euro issue, venture funding etc. These sources are useful in

different situations. They are classified based on time period, ownership and control, and their

source of generation. Sources of finance are the most explored area especially for the entrepreneurs

about to start a new business. It is perhaps the toughest part of all the efforts. There are various

sources of finance classified based on time period, ownership and control, and source of generation

of finance.

Having known that there are many alternatives of finance or capital, a company can choose from.

Choosing right source and the right mix of finance is a key challenge for every finance manager.

The process of selecting right source of finance involves in-depth analysis of each and every source

of finance. For analyzing and comparing the sources of finance, it is required to understand all

characteristics of the financing sources. There are many characteristics on the basis of which

sources of finance are classified.

On the basis of a time period, sources are classified into long term, medium term, and short term.

Ownership and control classify sources of finance into owned capital and borrowed capital.

Internal sources and external sources are the two sources of generation of capital. All the sources

of capital have different characteristics to suit different types of requirements. Let’s understand

them in a little depth.

According to time-period:

Sources of financing a business are classified based on the time period for which the money is

required. Time period is commonly classified into following three:

Long term sources of finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20

years or maybe more depending on other factors. Capital expenditures in fixed assets like plant

and machinery, land and building etc of a business are funded using long-term sources of finance.

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Part of working capital which permanently stays with the business is also financed with long-term

sources of finance. Long term financing sources can be in form of any of them:

• share capital or equity shares

• preference capital or preference shares

• retained earnings or internal accruals

• debenture / bonds

• term loans from financial institutes, government, and commercial banks

• venture funding

• asset securitization

• international financing by way of euro issue, foreign currency loans, etc.

The following points highlight the five long-term sources of fund of a company. The long-term

sources are: 1. Equity shares 2. Preference shares 3. Debentures 4. Loans from financial institutions

and 5. Retained earnings.

Equity shares:

It represents the ownership capital of a firm. A public limited company may raise funds from

public or promoters as equity share capital by issuing ordinary equity shares.

Ordinary shareholders are those the owners of which receive their dividend and return of capital

after the payment to preference shareholders.

They undertake the risk of the company. They elect directors and have total control over the

management of the company. These shareholders are paid dividends only when there are

distributable profits. As equity shares are paid only on liquidation, this source has the minimum

risk.

The liability of equity shareholders is limited up to the face value of the shares. Further, equity

share capital provides a security to other investors of funds. Hence, it will be easier to raise further

funds for companies having adequate equity share capital.

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Advantages and disadvantages:

Advantages:

The equity share capital offers the following advantages:

1. It is one of the most important long-term source of funds.

2. There are no fixed charges attached to ordinary shares. If a company earns enough divisible

profits it will be able to pay a dividend but there is no legal obligation to pay dividends.

3. Equity share capital has no maturity date and hence the company has no obligation to redeem.

4. The firm with the longer equity base will have greater ability to raise debt finance on favourable

terms. Thus issue of equity share increases the creditworthiness of the firm.

5. Dividend earnings are exempted from tax in the hands of investors. However, the company

paying equity dividend will have to pay tax on it.

6. The equity shareholders enjoy full voting right and participate in the management of the

company.

7. The company can issue further share capital by making right issue or bonus issue etc.

8. If the company earns more profit, more dividend is paid. So the value of goodwill of the

company increases, it ultimately leads to appreciate the market value of equity shares of the

company.

9. In India, returns from the sale of ordinary shares in the form of capital gains are subject to capital

gains tax rather than corporate tax.

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Disadvantages:

The following are the disadvantages in raising finance by issue of ordinary shares:

1. Dividends payable to ordinary shareholders are not deductible as an expense for the purpose of

computation of tax but debenture interest is tax deductible. So, the cost of equity capital is usually

higher than other source of funds. Further, the rate of return required by equity shareholders are

higher than the rate of return required by other investors.

2. The company has no statutory obligation for the payment of dividend on equity shares. So, the

risk of getting the dividend by the equity shareholders is very high. They may get higher rate of

dividend or lower rate of dividend or no dividend at all.

3. The issue of new equity shares to outsiders dilutes the control of existing owners. So small firms

normally avoid equity financing as they may not like to share control with outsiders.

4. The problem of over-capitalization may arise because of excess issue of equity shares.

5. Trading on equity is not possible, if the entire capital structure is composed of equity shares.

6. Unlike debenture holders, equity shareholders do not get fixed rate of return on their investment.

So the investors expecting regular flow of permanent income are not interested to invest equity

shares.

Sweat equity shares:

Section 79A of the companies act, 1956, has defined sweat equity shares as those shares which are

issued by a company to its employees or directors at a discount or for consideration other than cash

for providing know-how or making available rights in the nature of intellectual property rights or

value addition. Such shares are treated as the reward to the employees or directors.

The company may issue sweat equity shares if it has been authorised by a special resolution passed

in the general meeting and not less than one year has elapsed since the date of commencement of

business. The sweat equity shares of the company must be listed on a recognised stock exchange

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and all the restrictions and provisions relating to equity shares shall be applicable to sweat equity

shares.

Right shares:

If an existing company wants to make a further issue of equity shares, the issue must first be offered

to the existing shareholders. The method of issuing shares is called right issue. The existing

shareholders have right to entitlement of further shares in proportion to their existing shareholding.

For a shareholder who does not want to buy the right shares, his right of entitlement can be sold to

someone else. The price of right shares will be generally fixed above the nominal value but below

the market price of the shares.

Section 81 of the companies act, 1956, provides for the further issue of shares to be first offered

to the existing members of the company, such shares are known as ‘right shares’ and the right of

the members to be so offered is called the ‘right of pre-emption’.

Bonus shares:

Sometimes a company may not be in a position to pay cash dividends in spite of adequate profits

because of the adverse effect on the working capital of the company. However, to satisfy the equity

shareholders, the company may issue shares—without payment being required to— its existing

equity shareholders.

These shares are known as bonus shares or capitalisation of retained earnings. These shares are

issued out of accumulated or undistributed profits to shareholders. Bonus shares may also be issued

when a company wants to build up cash resources for expansion, or other purposes like repayment

of liability.

Preference shares:

These are shares which carry the following two rights:

(i) the right to receive dividend at a fixed rate before any dividend is paid on other shares.

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(ii) the right to return of capital in the case of winding-up of company, before the capital of the

equity shareholders is returned.

Long-term funds from preference shares are raised by a public issue of shares. It does not require

any security nor ownership of a firm is affected. It has some characteristics of equity capital and

some of debt capital. It resembles equity as preference dividend, like equity dividend is not tax

deductible payment.

Again, it is similar to debt capital in the following ways:

(i) the rate of preference dividend is fixed,

(ii) preference share capital is redeemable in nature, and

(iii) preference shareholders do not enjoy the right to vote.

If preference dividend is not paid in a year of loss, it is carried over to the subsequent year till there

is sufficient profits to pay the cumulative dividends. Cumulative convertible preference shares

(ccps) carry a cumulative dividend specified limit for a period, say 3 years on expiry of which

these shares are compulsorily converted into equity shares.

These shares are generally issued to finance new projects, expansion programme, modernisation

scheme etc. And also to provide further working capital.

Advantages and disadvantages of preference shares:

The advantages of preference shares are:

1. The company can raise long-term funds by issuing preference shares.

2. Preference shareholders normally do not carry voting right. Hence, there is no dilution of

control.

3. There is no legal binding to pay preference dividend. A company will not face any legal action

if it fails to pay dividend.

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4. There is no take-over risk. The shareholders become sure of their dividend from such

investment.

5. There is a leveraging advantage since it has fixed charges.

6. Preference share capital is generally regarded as part of net worth. Hence it increases the

creditworthiness of the firm.

7. Assets are not secured in favour of preference shareholders. The mortgageable assets of the

company are freely available.

8. Preference shareholders enjoy the preferential right as to the payment of dividend and return of

capital.

The disadvantages of preference shares are:

1. The dividend paid to preference shareholders is not a tax deductible expense. Hence it is a very

expensive source of financing.

2. Preference shareholders get voting right if the company fails to pay preference dividends for a

certain period.

3. Preference shareholders have preferential claim on the assets and earnings of the firm over

equity shareholders.

Types of preference shares:

The various types of preference shares are:

(i) cumulative preference shares:

The holders of these shares have the right to receive the arrears of dividend if for any year it has

not been paid because of insufficient profit.

(ii) non-cumulative preference shares:

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The holders of these shares have the right to receive dividend out of the profits of any year. In case

profits are not available in a year, the holders get nothing, nor can they claim unpaid dividends in

subsequent years.

(iii) participating preference shares:

The holders of these shares are entitled to a fixed preferential dividend and in addition, carry a

right to participate in the surplus profits along with equity shareholders after dividend at a certain

rate has been paid to equity shareholders.

Again, in the event of liquidation of the company, if after paying back both the preference and

equity shareholders, there is still any surplus left, then the participating preference shareholders

get additional shares in the surplus assets of the company.

(iv) non-participating preference shares:

These preference shares have no right to participate in the surplus profits of the company on its

liquidation. Such shareholders are entitled to a fixed rate of dividend only.

(v) convertible preference shares:

These preference shares can be converted into equity shares after a specified period of time. The

conversion of such shares can be made as per the provisions of the articles of association.

(vi) non-convertible preference shares:

Non-convertible preference shares are those shares which cannot be converted into equity shares.

(vii) redeemable preference shares:

These preference shares are redeemed before liquidation of the company as per terms of issue in

accordance with the provisions of articles of association.

(viii) irredeemable preference shares:

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These preference shares are not redeemed before liquidation of the company. Such shares are not

redeemed unless a company is liquidated. After the commencement of companies (amendment)

act, 1988, no company can issue irredeemable preference shares or preference shares which are

redeemable after the expiry of a period of ten years from the date of their issue.

Debentures:

A debenture is a document of acknowledgement of a debt with a common seal of the company. It

contains the terms and conditions of loan, payment of interest, redemption of the loan and the

security offered (if any) by the company.

According to section 2(12) of the companies act, 1956, debenture includes debenture stock, bonds

and any other securities of a company, whether constituting a charge on the assets of the company

or not.

Thus, a debenture has been defined as acknowledgement of debt, given under the common seal of

the company and containing a contract for the repayment of the principal sum at a specified date

and for the payment of interest at fixed rate/per cent until the principal sum is repaid and it may or

may not give the charge on the assets to the company as security of loan. It is an instrument for

raising long-term debt.

Debenture holders are the creditors of the company. They have no voting rights in the company.

Debenture may be issued by mortgaging any asset or without mortgaging the asset, i.e., debentures

may be secured or unsecured.

Interest on debenture is payable to debenture holders even when the company does not make profit.

The cost of debenture is very low as the interest payable on debentures is charged as an expense

before tax.

Types of debentures:

Debentures may be classified as:

1. Bearer debentures:

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These debentures are transferable like negotiable instruments, by mere delivery. The holder of

such debenture receives the interest when it become due. The transfer of such debenture is recorded

in the register of the company.

2. Secured or Mortgage Debenture:

These debentures are secured by creating a charge on the assets of the company. The charge may

be fixed or floating. If a company fails to pay debentures interest in due time or repay the principal

amount, the debenture holders can recover their dues by selling the mortgaged assets.

3. Simple or Naked Debentures:

When debentures are issued without any charge on the assets of the company, such debentures are

called naked or unsecured debentures.

4. Redeemable Debentures:

These are debentures which are issued for a specified period of time. On the expiry of that specified

time the company has the right to pay back the debenture holders. The redemption may be effected

by direct payment or by purchase and cancellation of own debenture or by annual drawings or by

periodical instalments etc.

5. Registered Debentures:

These are the debentures regarding which the names, addresses and other particulars of holdings

of the debenture holders are recorded in a register maintained by the company. Transfer of these

debentures will take place only on the execution of the transfer deed. Interest is payable to the

person whose name is registered with a company.

6. Irredeemable Debentures:

These are the debentures which are not repayable during the lifetime of the company and will be

repaid only when the company goes into liquidation.

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7. Convertible Debentures:

A company may issue convertible debentures in which case an option is given to the debenture

holders to convert them into equity or preference shares at stated rates of exchange, after a certain

period. Such debentures—once converted into shares cannot be reconverted into debentures.

Convertible debentures may be fully or partly convertible.

8. Non-Convertible Debentures:

These are the debentures which are not converted into shares and are redeemed at the expiry of

specified period.

9. Right Debentures:

These debentures are issued to augment working capital finance in a long-term basis.

Advantages and Disadvantages of Debentures:

The advantages of debentures may be summarised:

(i) The cost of debenture is much lower than the cost of equity or preference share capital since

interest on debenture is a tax-deductible expense.

(ii) There is a possibility of trading on equity (i.e., greater return on equity capital can be given, if

the company is able to earn higher rate of return than the fixed rate of interest paid to the debenture

holders.)

(iii) There is no dilution of control of the company by the issue of debentures. As the debenture

holders have no voting rights, so the issue of debenture does not affect the management of the

company.

(iv) Interest on debenture is a charge against profit. It is an admissible expense for the purpose of

taxation. Hence; tax liability on the company’s profits is reduced which result in the debentures as

a source of finance.

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(v) Investors prefer debenture investment than equity or preference investment as the former

provides a regular flow of permanent income.

(vi) During inflation, debenture issue is advantageous. The fixed monetary outgo dimin¬ishes in

real terms as the price level rises.

(vii) Debentures are secured on the assets of the company and, therefore, carry lesser risk and

assured return on investment.

(viii) At the time of winding-up, the debenture holders are placed before the equity or preference

share capital providers.

(ix) Debentures can be redeemed when a company has surplus fund.

The disadvantages of debentures can be summarised:

(i) The cost of issuing debentures is very high because of higher rate of stamp duty.

(ii) Debenture financing involves fixed interest and principal repayment obligation. Any failure to

meet these obligations may paralyze the company’s operations.

(iii) Debenture financing increases the financial risk of the company. This will, in turn increase

the cost of capital.

(iv) Trading on equity is not always possible.

(v) There is a limit to the extent to which funds can be raised through long-term debt.

(vi) The debenture holders are treated as creditors of the company. They have no voting rights of

the. company so the debenture holders become less interested in the affairs of the company.

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Loans from Financial Institutions:

In India specialised financial institutions provide long-term financial assistance to private and

public firms. Generally firms obtain long-term debt by raising term loans. Term loans, also referred

to as term finance, represent a source of debt finance which is repayable in less than 10 years.

Before giving a term loan to a company the financial institutions must be satisfied regarding the

technical, economical, commercial, financial and managerial viability of project for which the loan

is needed. Term loans are secured borrowings and a significant source of finance for investment

in the form of fixed assets and also in the form of working capital needed for new project.

The following financial institutions provide long-term capital in India:

(i) All Nationalized Commercial Banks.

(ii) Development Banks which include.

(a) Industrial Development Bank of India

(b) Small Industries Development Bank of India

(c) Industrial Finance Corporation of India

(d) Industrial Credit and Investment Corporation of India

(e) Industrial Reconstruction Bank of India.

(iii) Government Financial Institutions which include.

(a) State Finance Corporation

(b) National Small Industries Corporation

(c) State Industrial Corporation

(d) State Small Industries Development Corporation.

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(iv) Other investment institutes which include.

(a) Life Insurance Corporation of India

(b) General Insurance Corporation of India

(c) Unit Trust of India.

Source of Fund # 5. Retained Earnings:

When a company retains a part of undistributed profits in the form of free reserves and the same

is utilised for further expansion and diversification programmes, is known as ploughing back of

profit or retained earnings. These funds belong to the equity shareholders. It increases the net worth

of the business.

Although it is essentially a means of long-term financing for expansion and development of a firm,

and its availability depends upon a number of factors such as the rate of taxation, the dividend

policy of the firm, Government policy on payment of dividends by the corporate sector, extent of

profit earned and upon the firm’s appropriation policy etc.

Advantages and Disadvantages:

The advantages of ploughing back of profits are:

1. It is the cheapest method of raising capital

2. It has no specific cost of capital

3. It increases the net worth of business

4. There is no dilution of control of present owners

5. It does not require any pledge, mortgage etc. like other loans.

6. It provides required capital for expansion and development.

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7. Firms do not need to depend on lenders or outsiders if retained earnings, are readily available.

8. It increases the reputation of the business.

It suffers from the following limitations:

1. It may lead to cause of dissatisfaction among the shareholders as they receive-a low rate of

dividend.

2. Management may fail to properly use the profits retained.

3. Ploughing back or reinvestment of profit means depriving the shareholders a portion of the

earning of the company. As a result, share price may come down in the market.

4. It may lead to over-capitalization because of capitalization of profits.

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METHODS OF CAPITAL INVESTMENT DECISION

Net Present Value Method:

Net Present Value (NPV) is the difference between the present value of cash inflows and the

present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a

projected investment or project.

The following is the formula for calculating NPV:

Net Present Value (NPV)

where

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate, and

t = number of time periods

A positive net present value indicates that the projected earnings generated by a project or

investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally,

an investment with a positive NPV will be a profitable one and one with a negative NPV will result

in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that the only

investments that should be made are those with positive NPV values.

When the investment in question is an acquisition or a merger, one might also use the Discounted

Cash Flow (DCF) metric.

Apart from the formula itself, net present value can often be calculated using tables, spreadsheets

such as Microsoft Excel or Investopedia’s own NPV calculator.

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Determining the value of a project is challenging because there are different ways to measure the

value of future cash flows. Because of the time value of money (TVM), money in the present is

worth more than the same amount in the future. This is both because of earnings that could

potentially be made using the money during the intervening time and because of inflation. In other

words, a dollar earned in the future won’t be worth as much as one earned in the present.

The discount rate element of the NPV formula is a way to account for this. Companies may often

have different ways of identifying the discount rate. Common methods for determining the

discount rate include using the expected return of other investment choices with a similar level of

risk (rates of return investors will expect), or the costs associated with borrowing money needed

to finance the project.

Discounted Pay Back Method

The discounted payback period is a capital budgeting procedure used to determine the profitability

of a project. A discounted payback period gives the number of years it takes to break even from

undertaking the initial expenditure, by discounting future cash flows and recognizing the time

value of money. The net present value aspect of the discounted payback period does not exist in a

payback period in which the gross inflow of future cash flows are not discounted.

A key ratio that is used to determine the time it would take for an investor to double their money

in a stock investment. The price-to-earnings growth payback period is the time it would take for a

company's earnings to equal the stock price paid by the investor. A company's PEG ratio is used

rather than their price-to-earnings ratio because it is assumed that a company's earnings will grow

over time.

The best reason for calculating the PEG payback period is to determine the riskiness of an

investment. Generally, the longer the payback period the riskier an investment becomes. This is

because the payback period relies on the assessment of a company's earnings potential. It is harder

to predict such potential further into the future, and subsequently there is a greater risk that those

returns will not occur.

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Internal Rate of Return Method:

Internal rate of return (IRR) is a metric used in capital budgeting measuring the profitability of

potential investments. Internal rate of return is a discount rate that makes the net present value

(NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same

formula as NPV does.

The following is the formula for calculating NPV:

where:

Ct = net cash inflow during the period t

Co= total initial investment costs

r = discount rate, and

t = number of time periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount

rate r, which is here the IRR. Because of the nature of the formula, however, IRR cannot be

calculated analytically, and must instead be calculated either through trial-and-error or using

software programmed to calculate IRR.

Generally speaking, the higher a project's internal rate of return, the more desirable it is to

undertake the project. IRR is uniform for investments of varying types and, as such, IRR can be

used to rank multiple prospective projects a firm is considering on a relatively even basis.

Assuming the costs of investment are equal among the various projects, the project with the highest

IRR would probably be considered the best and undertaken first.

While IRR is a very popular metric in estimating a project’s profitability, it can be misleading if

used alone. Depending on the initial investment costs, a project may have a low IRR but a high

NPV, meaning that while the pace at which the company sees returns on that project may be slow,

the project may also be adding a great deal of overall value to the company.

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A similar issue arises when using IRR to compare projects of different lengths. For example, a

project of a short duration may have a high IRR, making it appear to be an excellent investment,

but may also have a low NPV. Conversely, a longer project may have a low IRR, earning returns

slowly and steadily, but may add a large amount of value to the company over time.

Another issue with IRR is not one strictly inherent to the metric itself, but rather to a common

misuse of IRR. People may assume that, when positive cash flows are generated during the course

of a project (not at the end), the money will be reinvested at the project’s rate of return. This can

rarely be the case. Rather, when positive cash flows are reinvested, it will be at a rate that more

resembles the cost of capital. Miscalculating using IRR in this way may lead to the belief that a

project is more profitable than it actually is in reality. This, along with the fact that long projects

with fluctuating cash flows may have multiple distinct IRR values, has prompted the use of another

metric called modified internal rate of return (MIRR). MIRR adjusts the IRR to correct these

issues, incorporating cost of capital as the rate at which cash flows are reinvested, and existing as

a single value. Because of MIRR’s correction of the former issue of IRR, a project’s MIRR will

often be significantly lower than the same project’s IRR.

Profitability Index Method

The profitability index is an index that attempts to identify the relationship between the costs and

benefits of a proposed project through the use of a ratio calculated as:

Profitability

PV of future cash flows/Investment

A ratio of 1.0 is logically the lowest acceptable measure on the index, as any value lower than 1.0

would indicate that the project's PV is less than the initial investment. As values on the profitability

index increase, so does the financial attractiveness of the proposed project.

Profitability index is an appraisal technique applied to potential capital outlays. The technique

divides the projected capital inflow by the projected capital outflow to determine the profitability

of a project. The main feature of using profitability index is the technique disregards project size.

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Therefore, projects with larger cash inflows may result in lower profitability index calculations

because their profit margin is not as high.

The present value of future cash flows requires the implementation of time value of money

calculations. Cash flows are discounted the appropriate number of periods to equate future cash

flows to current monetary levels. This discounting occurs because the value of $1 does not equate

the value of $1 received in one year. Because the $1 received now may be invested and gain value,

money received closer to the present is considered to have more value than money received further

in the future.

The discounted projected cash outflows represent the initial capital outlay of a project. The initial

investment required is only the cash flow required at the start of the project; all other outlays may

occur at any point in the project's life, and these are factored into the calculation through the use

of discounting in the numerator. These additional capital outlays may factor in benefits relating to

taxation or depreciation.

Profitability index calculations cannot be negative and must be converted to a positive figure

before they are useful. Calculations greater than one indicate the future anticipated discounted cash

inflows of the project are greater than the anticipated discounted cash outflows. Calculations less

than one indicate the deficit of the outflows is greater than the discounted inflows and the project

should not be accepted. Calculations that equal one brings about situations of indifference where

any gains or losses from a project are minimal.

When using the profitability index exclusively, calculations greater than one are ranked based on

highest calculation. When limit capital is available and projects are mutually exclusive, the project

with the highest profitability index is to be accepted as it indicates the project with the most

productive use of limited capital. Profitability index is also called the benefit-cost ratio for this

reason. Although some projects result in a higher net present value, those projects may be passed

over because they do not the highest profitability index and do not represent the most beneficial

usage of company assets.

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WEBLIOGRAPHY

✓ http://www.investopedia.com/terms/w/workingcapital.asp

✓ https://en.wikipedia.org/wiki/Working_capital

✓ http://accountlearning.blogspot.in/2011/07/factors-affecting-working-capital-or.html

✓ https://efinancemanagement.com/working-capital-financing/methods-for-estimating-

working-capital-requirement

✓ https://efinancemanagement.com/working-capital-financing/working-capital-calculation-

percentage-of-sales-method

✓ https://efinancemanagement.com/working-capital-financing/working-capital-estimation-

operating-cycle-method

✓ https://efinancemanagement.com/working-capital-financing/working-capital-calculation-

regression-analysis-method

✓ http://www.yourarticlelibrary.com/economics/capital-formation/working-capital-

definition-and-operating-cycle-explained-with-diagram/41043/

✓ http://www.investinganswers.com/financial-dictionary/businesses-corporations/net-operating-

cycle-2538

✓ http://www.investopedia.com