MCM606_Financial Management-converted

his helps the firm to retain its cash resources for a longer duration to meet the short S term requirements and sudden expenses. Even the organization can invest this cash in O a profitable opportunity for that particular credit period to generate additional income. A KEY WORDS R C • W ales Forecast: Sales forecasting is the process of estimating future sales. Accurate sales forecasts enable companies to make informed business decisions and predict short-term and long-term performance. • perating Cycle method: Operating cycle method for estimating working capital is based on the duration of the operating cycle. Longer the period of the cycle, bigger will be the working capital requirements. Operating cycle means the cycle of raw material to work in progress to finished goods to accounts payable and finally to cash • ccounts Receivable : Accounts receivable is the amount owed to a company resulting from the company providing • egression Analysis: The Regression analysis, a statistical tool, is used to estimate the working capital and its components. It establishes an equation relationship between revenue and working capital goods and/or services on credit. The term trade receivable is also used in place of accounts receivable • ash Management: it entails management of cash for day to day activities as well as maintaining cash for meeting the desired objectives. LEARNING ACTIVITY 1. hich type of working capital method is suitable for a large manufacturing concern? 2. Explain the importance of proper planning and control of working capital in a large manufacturing concern 148 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT END QUESTIONS (MCQ AND DESCRIPTIVE) P L A. Descriptive Questions: P P 1. Explain the different methods of working capital briefly with example of infrastructure industry 2. Explain the objectives of cash management to avoid insolvency in a business 3. Write a note on Receivable management” 4. Explain sales forecast method and regression analysis method for working capital determination to forecast sales of a new product. 5. Explain sales forecast method and adjusted profit and loss method in working capital determination. Which of the following is a basic principle of finance as it relates to the management of working capital? B. Multiple Choice Questions 1. Which of the following is a basic principle of finance as it relates to the management of working capital? a. rofitability varies inversely with risk. b. iquidity moves together with risk. c. rofitability moves together with risk. d. rofitability moves together with liquid 3. The amount of current assets required to meet a firm's long-term minimum needs is referred to as working capital. a. p ermanent t n b. g emporary c. et d. ross 149 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Having defined working capital as current assets, it can be further classified according to . a. f inancing method and time r t b. N ate of return and financing method t c. f ime and rate of return c c d. one of these 5. \"Net working capital\" means the same thing as . a. otal assets b. ixed assets c. urrent assets d. urrent assets minus current liabilities. Answer 1. c) 2. a) 3. c) 4. a) 5. d) REFERENCES • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. 150 CU IDOL SELF LEARNING MATERIAL (SLM)

• Brigham and Ehrhardt, Financial Management: Theory & Practice, Thomson ONE, 2010 •V an Horne: Fundamentals of Financial Management, Prentice Hall, 2008 151 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-11 INVENTORY MANAGEMENT Structure Learning Objectives Introduction Meaning Motives for holding inventory, Tools and techniques for Inventory Management Summary Keywords Learning Activity Unit End Questions References LEARNING OBJECTIVES After studying this unit you will be able to • Describe the concept of inventory management • State the motive of holding inventory • Evaluate techniques of Inventory Management INTRODUCTION Inventory or stock refers to the goods and materials that a business have for the sale .In stock w contain is all goods which are a business keep for sale like raw material, work in process, h finished goods. Stock is one of the most important assets for all type business. An optimum level of inventory is managed and maintained for smooth running and profit generate is very essentials. Inventory management refers to the process of ordering, storing and using a company's inventory. This includes the management of raw materials, components and finished products, as well as warehousing and processing such item It is important to manage inventory efficiently as it plays an important role in various aspects of business. Thus inventory management includes proper planning of buying, managing, warehousing and accounting of inventory. Businesses having proper inventory management systems are able to know: • hat to buy, • ow much to buy, 152 CU IDOL SELF LEARNING MATERIAL (SLM)

• w here to buy, a W • t what time to buy T T • T here to store etc. Now, various departmental heads of business would always disagree with the issue of inventory. For instance, the finance head would want to invest lesser amount in inventory given the cost involved and idle inventory impacting the profitability. Likewise, the production manager would want to invest more in inventory to avoid running out of stock and to produce goods uninterruptedly. The ultimate aim of inventory management is to maintain adequate stock levels. This is because excessive inventory leads to blocking of working capital. And inadequate inventory results in shortage of raw material leading to stalled production process. MEANING Inventory management is a systematic approach to sourcing, storing, and selling inventory—both raw materials (components) and finished goods (products). In business terms, inventory management means the right stock, at the right levels, in the right place, at the right time, and at the right cost as well as price. It is how you track and control your business’ inventory as it is bought, manufactured, stored, and used. It governs the entire flow of goods — from purchasing right through to sale — ensuring that you always have the right quantities of the right item in the right location at the right time. Inventory management is an approach for keeping track of the flow of inventory. It starts right from the procurement of goods and its warehousing and continues to the outflow of the raw material or stock to reach the manufacturing units or to the market, respectively. The process can be carried out manually or by using an automated system. The objectives of inventory management • he main objectives of inventory management are operational and financial .The following are the objectives of inventory management : • o ensure continuous supply of materials, spares and finished goods so that the production doesn’t suffer and the customers demand are met. • 153 CU IDOL SELF LEARNING MATERIAL (SLM)

o avoid the over-stocking and under stocking of inventory T T • T o maintain investments in inventories at the optimum level as required by the operational and sales activities • o keep material cost under control so that they contribute in reducing the cost of production and overall costs. • o minimize losses through deterioration , pilferage , wastages MOTIVES FOR HOLDING INVENTORY Holding Inventory is the Inventory helps the organization to prevent fluctuations in demand & supply from affecting sales or production. The main objective of holding inventories is to reduce the cost associated with investment in inventory and maintaining efficiency in production and sales operations. A company has various motives for holding the inventory as stated below: (a) Transaction Motive: The Company may be required to hold the inventory in order to facilitate the smooth and uninterrupted production and sale operations. It may not be possible for the company to procure the raw material whenever necessary. There may be a time lag between the demand for the material and its supply. Hence it is needed to hold the raw material inventory. Similarly, it may not be possible to produce the goods immediately after they are demanded by the customers. Hence it is needed to hold the finished goods inventory. They need to hold work in progress may arise due to the production cycle. (b) Precaution Motive: In addition to the requirement to hold the inventory for routine transactions, the company may like to hold them to guard against the risk of unpredictable changes in demand and supply forces. E.g., the supply of raw material may get delayed due to factors like a strike, transport, disruption, short supply, lengthy processes involved in the import of raw material etc. hence the company should maintain sufficient level of inventory to take care of such situations. Similarly, the demand for finished goods may suddenly increase (especially in case of the seasonal type of products) and if the company is unable to supply them, it may mean gain of competition. Hence, the company will like to maintain a sufficient supply of finished goods. (c) Speculative Motive: The Company may like to purchase and stock the inventory in the quantity which is more than needed for production and sales purpose. This may be with the intention to get an advantage in term of quantity discounts connected with bulk purchasing or anticipating price rise. 154 CU IDOL SELF LEARNING MATERIAL (SLM)

Inventory management is primarily about specifying the size and placement of stocked goods. Inventory management is required at different locations within a facility or within multiple locations of a supply network to protect the regular and planned course of production against the random disturbance of running out of materials or goods. The scope of inventory management also concerns the fine lines between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, replenishment, returns, and defective goods and demand forecasting. Balancing these competing requirements leads to optimize inventory levels, which is an on-going process as the business needs shift and react to the wider environment. Other Motives There are some other objectives of holding inventory such as: - To receive quantity discount and price discount while purchasing materials in bulk quantity. - To minimize ordering cost and carrying cost - To minimize production set of costs. The firm holds inventory to ensure the continuous production or supply and to avoid the situation of stock out and in this process, it incurs the carrying and handling costs. INVENTORY CONTROL TOOLS AND TECHNIQUES Inventory Management Techniques Below is a list of some of the most popular and effective inventory management techniques you can use to improve your business. 1. E conomic Order Quantity Economic order quantity is the lowest amount of inventory you must order to meet peak customer demand without going out of stock and without producing obsolete inventory. Its purpose is to reduce inventory as much as possible to keep the cost of inventory as low as possible. To help you calculate EOQ, here is the formula from Kenneth Boyd, author of Cost Accounting for Dummies: Economic order quantity uses three variables: demand, relevant ordering cost, and relevant carrying cost. Use them to set up an EOQ formula: 155 CU IDOL SELF LEARNING MATERIAL (SLM)

• D emand: The demand, in units, for the product for a specific time period. R R • elevant ordering cost: Ordering cost per purchase order. M • A elevant carrying cost: Carrying costs for one unit. Assume the unit is in stock for the A time period used for demand. B C Note that the ordering cost is calculated per order. The carrying costs are calculated per unit. Here’s the formula for economic order quantity: Economic order quantity = square root of [(2 x demand x ordering costs) ÷ carrying costs] That’s easier to visualize as a regular formula: Q is the economic order quantity (units). D is demand (units, often annual), S is ordering cost (per purchase order), and H is carrying cost per unit. 2. inimum Order Quantity Minimum order quantity (MOQ) is the lowest set amount of stock that a supplier is willing to sell. If you can’t purchase the MOQ of a specific product, then the supplier won’t sell it to you. The purpose of minimum order quantities is to allow suppliers to increase their profits while getting rid of more inventory more quickly and weeding out the “bargain shoppers” simultaneously. A minimum order quantity is set based on your total cost of inventory and any other expenses you have to pay before reaping any profit – which means MOQs help wholesalers stay profitable and maintain a healthy cash flow. 3. BC Analysis ABC analysis of inventory is a method of sorting your inventory into 3 categories according to how well they sell and how much they cost to hold: • -Items – Best-selling items that don’t take up all your warehouse space or cost • -Items – Mid-range items that sell regularly but may cost more than A-items to hold • -Items – The rest of your inventory that makes up the bulk of your inventory costs while contributing the least to your bottom line 156 CU IDOL SELF LEARNING MATERIAL (SLM)

ABC analysis of inventory helps you keep working capital costs low because it identifies which items you should reorder more frequently and which items don’t need to be stocked often – reducing obsolete inventory and optimizing the rate of inventory turnover. 4. J ust In Time Inventory Management M Just-in-Time Inventory Management is simply making what is needed, when it’s needed, in L the amount needed. R M Many companies operate on a “just-in-case” basis – holding a small amount of stock in case P of an unexpected peak in demand. S JIT attempts to establish a “zero inventory” system by manufacturing goods to order; it P operates on a “pull” system whereby an order comes through and initiates a cascade response throughout the entire supply chain – signaling to the staff they need to order inventory or begin producing the required item. Here are some of the benefits of just-in-time inventory: • inimize costs such as rent and insurance by reducing your inventory • ess obsolete, outdated, and spoiled inventory • educe waste and increase efficiency by minimizing or eliminating warehousing and stockpiling, while maximizing inventory turnover • aintain healthy cashflow by ordering stock only when necessary • roduction errors can be identified and fixed faster since production happens on a smaller, more focused level, allowing easier adjustments or maintenance on capital equipment 5. afety Stock Inventory Safety stock inventory is a small, surplus amount of inventory you keep on hand to guard against variability in market demand and lead times. Safety stock plays an integral role in the smooth operations of your supply chain in various ways. Here are just a few: • 157 CU IDOL SELF LEARNING MATERIAL (SLM)

rotection against unexpected spikes in demand P • C A revention of stockouts • L L ompensation for inaccurate market forecasts A • F nd a buffer for longer-than-expected lead times You probably noticed that the benefits of safety stock are all tied to mitigating problems that could seriously harm your business. That’s because without safety stock inventory you could experience: • oss of revenue • ost customers • nd a loss in market share A safety stock formula is relatively straightforward and requires only a few inputs for calculation. Here’s the formula we recommend using if you’re just starting out: (Max Daily Sales x Max Lead Time in Days) – (Average Daily Sales x Average Lead Time in Days) = Safety Stock Inventory 6. IFO and LIFO are accounting methods used to value your inventory and report your profitability. FIFO (first in, first out) is an inventory accounting method that says the first items in your inventory are the first ones that leave – meaning you get rid of your oldest inventory first. LIFO (last in, first out) is an inventory accounting method that says the last items in your inventory are the first ones that leave – meaning you get rid of the newest inventory first. If you handle food inventory management or operate any business with perishable items, then you pretty much have to use FIFO. Otherwise, you’ll end up with obsolete inventory that you’ll have to write-off as a loss. With that said, LIFO is a great method for non-perishable homogeneous goods like stone or brick. So, if you get a fresh batch of items like these, you don’t need to rearrange your warehouse or rotate batches since they’ll be the first ones out anyway. 158 CU IDOL SELF LEARNING MATERIAL (SLM)

7. R eorder Point Formula B A reorder point formula tells you approximately when you should order more stock – that is, M when you’ve reached the lowest amount of inventory you can sustain before you need more. Here’s the reorder point formula you can use today: (Average Daily Unit Sales x Average Lead Time in Days) + Safety Stock = Reorder Point This equation can help you stop being a victim to market spikes and slumps and instead, consistently order the right amount of stock each month. 8. atch Tracking Batch tracking is sometimes referred to as lot tracking, and it’s a process for efficiently tracing goods along the distribution chain using batch numbers. From raw materials to finished goods, batch tracking allows you to see where your goods came from, where they went, how much was shipped, and when they expire if they have an expiration date. SUMMARY •I nventory management is the process of tracking stock from manufacturing through to fulfillment. There are many inventory control methods that help your brand operate more efficiently while providing you with higher levels of visibility and control. Essentially, inventory management software consists of the business applications that manage inventory for you. •I nventory control is far more robust than the old-school spreadsheet system. In many cases, you can monitor how much inventory you have at any given time across all your sales channels while utilizing reporting capabilities that provide insights into your business and customers. • anagement tools automate and streamline the inventory process while integrating with other tools, such as your eCommerce site, accounting, fulfillment, and other retail applications you need. There are a few inventory management techniques that can assist your brand’s efficiency and accuracy. Identifying reasoning behind missing or lost inventory is critical in your brand’s success, since brands live and die by their inventory. The two classic systems for managing independent demand inventory are 159 CU IDOL SELF LEARNING MATERIAL (SLM)

periodic review and perpetual review systems The economic order quantity (EOQ) A is the order quantity that minimizes total holding and ordering costs for the year. J Inventory management is a systematic approach to sourcing, storing, and selling J inventory—both raw materials (components) and finished goods (products). H •I n business terms, inventory management means the right stock, at the right levels, in the right place, at the right time, and at the right cost as well as price. Inventory serves a useful purpose in the supply chain. The two classic systems for managing independent demand inventory are periodic review and perpetual review systems. ... The economic order quantity (EOQ) is the order quantity that minimizes total holding and ordering costs for the year. •I n business terms, inventory management means the right stock, at the right levels, in the right place, at the right time, and at the right cost as well as price. • BC inventory management is a technique that’s based on putting products into categories in order of importance, with A being the most valuable and C being the least. Not all products are of equal value and more attention should be paid to more popular products. • ust In Time (JIT) inventory management lowers the volume of inventory that a business keeps on hand. It is considered a risky technique because you only purchase inventory a few days before it is needed for distribution or sale. • IT helps organizations save on inventory holding costs by keeping stock levels low and eliminates situations where deadstock - essentially frozen capital - sits on shelves for months on end. • owever, it also requires businesses to be highly agile with the capability to handle a much shorter production cycle. •I nventory Management is a practice of tracking and controlling the inventory orders, its usage and storage along with the management of finished goods that are ready for sale. Improper inventory management can lead to an increase in storage cost, working capital crunch, wastage of labor resources, increase in idle time, disruption of the supply chain, etc. All this leads to a reduction in sales and unsatisfied customers. Therefore, inventory management is an important aspect of the business which the management cannot afford to ignore. Effective and efficient management of the same is a must. 160 CU IDOL SELF LEARNING MATERIAL (SLM)

KEY WORDS/ ABBREVIATIONS E •I A nventory: Inventory is the array of finished goods or goods used in production J held by the company. S M • R conomic Order Quantity: The Economic Order Quantity (EOQ) is the number of C units that a company should add to inventory with each order to minimize the total costs of inventory.— •I nventory Management: It is a systematic approach of sourcing, storing and selling the inventory. Inventory management refers to the process of ordering, storing and using a company's inventory. This includes the management of raw materials, components and finished products, as well as warehousing and processing such items. • BC analysis: ABC analysis is an inventory categorization technique. ABC analysis divides an inventory into three categories—\"A items\" with very tight control and accurate records, \"B items\" with less tightly controlled and good records, and \"C items\" with the simplest controls possible and minimal records. • UST IN TIME: Just-in-time manufacturing, also known as just-in-time production or the Toyota Production System, is a methodology aimed primarily at reducing times within the production system as well as response times from suppliers and to customer • afety Stock : Safety stock is a term used by logisticians to describe a level of extra stock that is maintained to mitigate risk of stockouts (shortfall in raw material or packaging) caused by uncertainties in supply and demand • aterial Requirement: Material requirements planning (MRP) is a computer-based inventory management system designed to improve productivity for businesses. • eorder level: The stock level where fresh order is placed for economic order quantity. • 161 CU IDOL SELF LEARNING MATERIAL (SLM)

arrying Costs: It is the storage, insurance, obsolescence and opportunity costs with L the holding of inventories. W • ead Time: It is the time taken. replenish the inventories. LEARNING ACTIVITY 1. hat method of inventory technique is adopted for a garment store? 2. D o you think costs should be included in holding inventory? UNIT END QUESTIONS (DESCRIPTIVE AND MCQ) A. Descriptive Questions 1. Describe inventory management in a production process of biscuit 2. Explain the different techniques of inventory management to minimize wastages and to increase productivity 3. Explain the objectives of holding inventory to fulfill demand of Cadbury in a market 4. What are the motives of holding inventory in retail shop? 5. What are the roles played by inventory carrying costs and ordering costs in inventory management to amazon sellers? B. Multiple Choice Questions 1. Which of the following is not an inventory? a. Machines b. Raw material c. Finished products d. Consumable tools 162 CU IDOL SELF LEARNING MATERIAL (SLM)

2. The following classes of costs are usually involved in inventory decisions except a. Cost of ordering b. Carrying cost c. Cost of shortages d. Machining cost 3. The cost of insurance and taxes are included in a. Cost of ordering b. Set up cost c. Inventory carrying cost d. Cost of shortages 4. ‘Buffer stock’ is the level of stock a. Half of the actual stock b. At which the ordering process should start c. Minimum stock level below which actual stock should not fall d. Maximum stock in inventory 5. The minimum stock level is calculated as a. Reorder level – (Normal consumption x Normal delivery time) b. Reorder level + (Normal consumption x Normal delivery time) c. (Reorder level + Normal consumption) x Normal delivery time d. (Reorder level + Normal consumption) / Normal delivery time Answers 1. a), 2. d), 3. c) 4. c) 5. a) REFERENCES • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. 163 CU IDOL SELF LEARNING MATERIAL (SLM)

• James, C. (2014). Financial Management. New Delhi: Prentice-Hall. K B • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. • han and Jain, Financial Management, Tata McGraw-Hill, 2009 • righam and Houston, Fundamentals of Financial Management, Thomson ONE, 2009 164 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-12 LEVERAGE Structure Learning Objective Introduction 12.2 Meaning 12.3 Impact of Leverage 12.4 Operating Leverage and Financing Leverage Summary Keywords Learning Activity Self-Assessment 12.9 References LEARNING OBJECTIVES After studying this unit you will be able to • Assess the basic concepts of leverage • Learn impact of leverage • Describe operating leverage and financing leverage INTRODUCTION Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets the term leverage indicates the ability of a firm to earn higher return by employing fixed assets or debt. It shows the effects of the investment patterns or financing patterns adopted by the firm. The employment of an asset or source of funds for which the firm has to pay a fixed cost or interest has a considerable influence on the earnings available for equity shareholders. The fixed cost or interest acts as the fulcrum and the leverage magnifies the influence. By leveraging, a firm is able to magnify the returns to the shareholders by using fixed cost bearing assets or funds. It depends on the financial planning where it is desired that a small change in sales or EBIT will have a magnifying effect on EBIT or EPS respectively. It must however be noted that higher the degree of leverage, higher is the risk as well as well as return to the owners. 165 CU IDOL SELF LEARNING MATERIAL (SLM)

Definition of Leverage: The employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return is called leverage. Various authors have defined leverage in different ways. According to James C. Van Home, ‘Leverage refers to the use of fixed cost in an attempt to increase (or lever up) profitability’. In the words of J. E. Walter, ‘Leverage may be defined as percentage return on equity and the net rate of return on total capitalization’. Ezra Solomon defined leverage as ‘the ratio of net returns on shareholders equity and the net rate of return on total capitalization’. According to S. C. Kuchhal, the term leverage ‘is used to describe a firm’s ability to use fixed cost bearing assets or funds to magnify the return to its owners’. Thus leverage implies the use of fixed cost in an attempt to increase profitability. It can be defined as; leverage is the responsiveness of firm’s return to fluctuations in revenue and operating income, and the ability of a firm to magnify the influence resulting in higher return. Income Statement: For the purpose of an increased understanding MEANING The term leverage indicates the ability of a firm to earn higher return by employing fixed assets or debt. It shows the effects of the investment patterns or financing patterns adopted by the firm. The employment of an asset or source of funds for which the firm has to pay a fixed cost or interest has a considerable influence on the earnings available for equity shareholders. ‘Leverage refers to the use of fixed cost in an attempt to increase (or lever up) profitability’. Ezra Solomon defined leverage as ‘the ratio of net returns on shareholders equity and the net rate of return on total capitalization’. According to S. C. Kuchhal, the term leverage ‘is used to describe a firm’s ability to use fixed cost bearing assets or funds to magnify the return to its owners’. Thus leverage implies the use of fixed cost in an attempt to increase profitability. It can be defined as leverage is the responsiveness of firm’s return to fluctuations in revenue and operating income, and the ability of a firm to magnify the influence resulting in higher return. IMPACT OF LEVERAGE Every experienced organization knows when debt capital is more suitable for them and from which sources they should collects their debt funds. Every financial expert should consider 166 CU IDOL SELF LEARNING MATERIAL (SLM)

some factors before they will use debt funds. First of all, the impact of using leverage to the sales revenue of the organization. If the debt financing increase, the sales revenue of the firm will increase that indicates the positive potential profitability of a company. In other sense, if the leverage drop off the sales revenue of the company that indicates the potential losses of a company. Secondly, the financial manager should consider that, the use of debt funds will increase the return or not. If the return of the firm will increase, the value of the firm will increase that indicates the wealth maximization of the company. The debt overhangs theory of Myers predicts that higher leverage increases the probability of a firm for going positive NPV projects in the future, because in some states, the payoff from these investments to shareholder, after fulfilling debt obligations, is lower than the initial investment shareholders have to outlay. This under-investment reduces the growth option value of a firm. Thus, an increase in the leverage ratio can result in a lower stock price, all other factors equal. In a related study, Dimitrov and Jain find a negative relation between the annual change in leverage and the current year and next-year stock returns. They also find a negative relation between the leverage change and future earnings and argue that a firm may increase its borrowing when the underlying performance is expected to deteriorate. They conclude that the leverage change contains value relevant information about future stock returns. Thirdly, the major concern of the firm is market interest rate regarding loan or cost of capital of debt funds because there are inverse relationship between cost of capital and use of debt financing. Generally firm prefer to use debt funds when the cost of capital is relatively low than rate of return. In other way, if the market interest rate of loan is greater than the rate of return of investment. The loss will occur for the firm that may create financial risk. The negative relation between the leverage change and the stock price may also be consistent with the argument that default risk is priced. An increase in a firm’s leverage ratio may increase the firm’s likelihood of default. If the default risk is priced, the stock reacts with an immediate price drop but has higher expected return in the future. The negative effect of the leverage change on stock prices is stronger for firms that have higher leverages, higher default risks, or face more financial constraints. These results suggest that an increase in leverage ratio has a more severe adverse effect on stock price for firms that are more likely to suffer from debt overhang. Fourthly, the financial manager also considers the ability of firm to recover the losses of loan account. There is positive relationship between ability of firm to recover the loss and use of debt fund. Generally the firm have sufficient ability to recover the loss will use more debt fund in their capital structure. In other way, the firm have unable to recover the loss will get less debt fund from different sources. Fifthly, this is a huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. Finally the firm consider overall external environment such as political situation, economic condition and social cultural tendency etc. before using debt financing for the organization. 167 CU IDOL SELF LEARNING MATERIAL (SLM)

OPERATING LEVERAGE AND FINANCIAL LEVERAGE Operating leverage is a lesser known term or concept. Even if you do not borrow money you do not necessarily avoid the risk of operating leverage. Operating leverage measures a firm's fixed versus variable costs. The greater proportion of fixed costs, the greater the operating leverage. Like financial leverage, operating leverage magnifies results, making gains look better and losses look worse. Both operating and financial leverage increase risks because they make returns less predictable over time. The process of increasing the earning per share to the equity shareholders by increasing the amount of debt capital is called Financial Leverage. Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate the breakeven point of a business, as well as the likely profit levels on individual sales. The following two scenarios describe an organization having high operating leverage and low operating leverage. High operating leverage. A large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs. However, earnings will be more sensitive to changes in sales volume. Low operating leverage. A large proportion of the company’s sales are variable costs, so it only incurs these costs when there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales. Degree of operating Leverage=Total Contribution/EBIT Illustration 1: Calculate the degree of operating leverage from the following data: Sales: 1, 50,000 units at Rs 4 per unit. Variable cost per unit Rs 2. Fixed cost Rs. 150000 Interest charges Rs. 25000 168 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Leverage Financial leverage which is also known as leverage or trading on equity, refers to the use of debt to acquire additional assets. The use of financial leverage to control a greater amount of assets (by borrowing money) will cause the returns on the owner's cash investment to be amplified. Financial leverage is the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing .Financial leverage can be aptly described as the extent to which a business or investor is using the borrowed money. Business companies with high leverage are considered to be at risk of bankruptcy if, in case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in future. It is not that financial leverage is always bad. Financial leverage is a main source of financial risk. By issuing more debt, a company incurs the fixed costs associated with the debt (interest payments). The company’s inability to meet the obligations may result in financial distress or even bankruptcy. Highly leveraged companies may face significant financial problems during a recession because their operating income will rapidly decline and, thus, so will their overall profitability. Note that taxes do not affect the degree of financial leverage. A high degree of financial leverage indicates that even a small change in the company’s leverage may result in a significant fluctuation in the company’s profitability. Also, a high degree of leverage may translate to a more volatile stock price because of the higher volatility of the company’s earnings. Increased stock price volatility means the company is forced to record a higher expense for outstanding stock options, which represents a higher cost of debt. Therefore, companies with extremely volatile operating incomes should not take on substantial leverage because there is a high probability of financial distress for the business. Financial leverage is a main source of financial risk. By issuing more debt, a company incurs 169 CU IDOL SELF LEARNING MATERIAL (SLM)

the fixed costs associated with the debt (interest payments). The company’s inability to meet the obligations may result in financial distress or even bankruptcy. Highly leveraged companies may face significant financial problems during a recession because their operating income will rapidly decline and, thus, so will their overall profitability. Note that taxes do not affect the degree of financial leverage. A high degree of financial leverage indicates that even a small change in the company’s leverage may result in a significant fluctuation in the company’s profitability. Also, a high degree of leverage may translate to a more volatile stock price because of the higher volatility of the company’s earnings. Increased stock price volatility means the company is forced to record a higher expense for outstanding stock options, which represents a higher cost of debt. Therefore, companies with extremely volatile operating incomes should not take on substantial leverage because there is a high probability of financial distress for the business. Formula for Degree of Financial Leverage There are several ways to calculate the degree of financial leverage. The choice of the calculation method depends on the goals and context of the analysis. For example, a company’s management often wants to decide whether it should or should not issue more debt. In such a case, net income would be an appropriate measure of the company’s profitability: However, if an investor wants to determine the effects of the company’s decision to incur additional leverage, the earnings per share (EPS) is a more appropriate figure because of the metric’s strong relationship with the company’s share price However, it can lead to an increased shareholders’ return on investment. Also, very often, there are tax advantages related with borrowing, also known as leverage. Formula The most well-known financial leverage ratio is the debt-to-equity ratio (It is calculated as: Total debt / Shareholders Equity 170 CU IDOL SELF LEARNING MATERIAL (SLM)

Calculating financial leverage Financial leverage indicates the reliability of a business on its debts in order to operate. Knowing about the method and technique of calculating financial leverage can help you determine a business’ financial solvency and its dependency upon its borrowings. The key steps involved in the calculation of Financial Leverage are: Compute the total debt owed by the company. This counts both short term as well as long term debt, also including commodities like mortgages and money due for services provided. Estimate the total equity held by the shareholders in the company. This requires multiplying the number of outstanding shares by the stock price. The total amount thus obtained represents the shareholder equity. Divide the total debt by total equity. The quotient thus obtained represents the financial leverage ratio. Financial leverage is related to the following: U T • M se of capital structure to earn better returns and to reduce taxes. R M • P ells about capital structure of the firm. R • D easures financial risk. F • elates EBIT and EPS. • ore the financial leverage, more financial risk. • referred high. DFL = EBIT/EBT. • ise to financial risk. • egree of financial leverage relates to liabilities side in balance sheet (different source of finance). Operating Leverage is related to the following: 171 • CU IDOL SELF LEARNING MATERIAL (SLM)

irm ability to use fix costs to generate more returns. T M • R ells about fixed cost of the firm. H P • R easures operating risk of the business. D D • elates sales and EBIT. • igher the operating leverage, more operating risk. • referred low. • ise to business risk. • OL = Contribution/EBIT. • egree of operating leverage is higher than breakeven point. 172 CU IDOL SELF LEARNING MATERIAL (SLM)

Illustration 2: Calculate the degree of financial leverage from the following information: Capital structure: 10,000, Equity Shares of Rs 10 each Rs 1, 00,000. 5,000, 11 % Preference Shares of Rs 10 each Rs 50,000. 9% Debentures of Rs 100 each Rs 50,000. The EBIT of the company is Rs 50,000 and corporate tax rate is 45%. SUMMARY • O perating leverage can be defined as a firm's ability to use fixed costs (or expenses) to O generate better returns for the firm. Financial leverage can be defined as a firm's ability to increase better returns and to reduce the cost of the firm by paying lesser taxes. Inventory serves a useful purpose in the supply chain. The two classic systems for managing independent demand inventory are periodic review and perpetual review systems. ... The economic order quantity (EOQ) is the order quantity that minimizes total holding and ordering costs for the year. Operating leverage is an indication of how a company's costs are structured and is used to determine the break-even point for a company. The break-even point is where the revenue from sales covers both the fixed and variable costs of production. Financial leverage refers to the amount of debt used to finance the operations of a company. • perating leverage refers to the use of fixed operating costs such as depreciation, insurance of assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it does not include interest on debt capital. Higher the proportion of fixed operating cost as compared to variable cost, higher is the operating leverage, and vice versa. 173 CU IDOL SELF LEARNING MATERIAL (SLM)

• O perating leverage may be defined as the “firm’s ability to use fixed operating cost to F magnify effects of changes in sales on its earnings before interest and taxes.” L A • inancial leverage is primarily concerned with the financial activities which involve L raising of funds from the sources for which a firm has to bear fixed charges such as F interest expenses, loan fees etc. These sources include long-term debt (i.e., debentures, O bonds etc.) and preference share capital. E • E ong term debt capital carries a contractual fixed rate of interest and its payment is obligatory irrespective of the fact whether the firm earns a profit or not. • s debt providers have prior claim on income and assets of a firm over equity shareholders, their rate of interest is generally lower than the expected return in equity shareholders. Further, interest on debt capital is a tax deductible expense. KEY WORDS /ABBREVIATIONS • everage: Leverage is an investment strategy of using borrowed money— specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. • inancial Leverage: an increase in the value of the assets will result in a larger gain on the owner's cash, when the loan interest rate is less than the ... rate of increase in the asset's value. • perating Leverage: Operating leverage is a measure of how revenue growth translates into growth in operating income • arnings before interest and Tax: Earnings before interest and taxes (EBIT) is an indicator of a company's profitability. EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes • arnings available to shareholders: earnings available for common stockholders, take the company's after-tax profit -- also called net income or earnings -- and subtract any amount of that profit that must be distributed to a senior class of 174 CU IDOL SELF LEARNING MATERIAL (SLM)

shareholders. D A LEARNING ACTIVITY 1. firm has sales of rupees 10,00,000 variable cost of 700,000 & fixed cost 200,000 & debt of 500,000 at 10% rate of interest. What are the operating financial & composite leverage? 2.X YZ Company details: Sales = 7500,000 Variable cost = 4200,000 Fixed cost = 600,000 Debt = 4500,000 Interest = 9% Equity = 5500,000 Calculate: 1. Return on investment. 2. EBIT & EBT. 3. All types of leverages. UNIT END QUESTIONS (MCQ AND DESCRIPTIVE) A. Descriptive Types Questions 1. Explain the meaning of the term Leverage in IT Industry 2. Explain the importance of leverage to save taxes 3. Bob and Jim are both looking to purchase the same house that costs $500,000. Bob plans to make a 10% down payment and take a $450,000 mortgage for the rest of the payment (mortgage cost is 5% annually). Jim wants to purchase the house for $500,000 cash today. Who will realize a higher return on investment if they sell the house for $550,000 a year from 175 CU IDOL SELF LEARNING MATERIAL (SLM)

today? 4. Following is the cost information of a firm: Fixed cost = Rs. 50,000 Variable cost = 70% of sales Sales = Rs. 2,00,000 in previous year and Rs. 2,50,000 in current year. Find out percentage change in sales and operating profits when: (i) Fixed costs are not there (no leverage) (ii) Fixed cost is there (leveraged situation). 5. Following information is taken from the records of a hypothetical company: Calculate operating leverage under the following situations: B. Multiple Choice Questions o f 1. The measure of business risk is t w a. perating leverage t f b. w inancial leverage 176 c. otal leverage d. orking capital leverage 2. It is risky to have both operating leverage and leverage at high levels a. otal leverage b. inancial leverage c. orking capital leverage CU IDOL SELF LEARNING MATERIAL (SLM)

d. n one of the above 3. Financial leverage indicates changes in taxable income as result of change E o a. f BIT n b. o perating leverage f t c. N inancial leverage a d. m one of the above d A 4. An ideal situation would be to keep leverage low a. perating b. inancial c. otal leverage d. one of these 5. The combined effect of operating leverage and financial leverage is seen by of the two a. ddition b. ultiplication c. ivision d. ll of these Answers: 1. a) 2. b) 3. a) 4. a) 5. b) 177 CU IDOL SELF LEARNING MATERIAL (SLM)

REFERENCES P • Chandra, P. (2012). Financial Management. New Delhi: Tata McGraw Hill. • James, C. (2014). Financial Management. New Delhi: Prentice-Hall. • Khan, M.Y. & Jain, P.K. (2012). Financial Management. New Delhi: Tata McGraw Hill. • Pandey, I.M (2009). Financial Management. New Delhi: Vikas Publishing House. • Maheshwari S.N. (2014). Principles of Financial Management. New Delhi: Sultan Chand & Sons. • Kulkarni P.V. (2014). Financial Management. Mumbai: Himalaya Publishing House. •V an Horne: Fundamentals of Financial Management, Prentice Hall, 2008 • rasanna Chandra, Financial Management, McGraw Hill, 2008. 178 CU IDOL SELF LEARNING MATERIAL (SLM)