A Few Concepts

Differentiate among terms “Owners Equity”, “External Equity” and “Equity”.

Owners’ Equity means share capital, both equity share capital and preference share capital and reserves and surplus.

External Equity means all outside liabilities (inclusive of current liabilities and provisions). Also these are sometimes classified as equity and debt.

Equity means shareholders fund and Debt means long term borrowed fund (so short-term loans, current liabilities and provisions are excluded).

What do you mean by Stability Ratios.

These ratios concentrate on the long-term health of a business - particularly the
effect of the capital/finance structure on the business.

Gearing Ratio - Borrowing (all long-term debts + normal overdraft)/ Net Assets (or Shareholders' Funds)

Gearing (otherwise known as "leverage") measures the proportion of assets invested in a business that are financed by borrowing. In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest and repayment of debts are not "optional" in the same way as dividends. However, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows.

Interest cover ratio - Operating profit before interest / Interest

This measures the ability of the business to "service" its debt. Are profits sufficient to be able to pay interest and other finance costs?

Define briefly term “Trading on Equity”.

The term ‘trading on equity’ is derived from the fact that debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm’s earnings and hence want to be protected in terms of earnings and values represented by equity capital. Since fixed charges do not vary with the firms earnings before interest and tax, a magnified effect is produced on earnings per share. Whether the leverage is favourable in the increase in earnings per share more proportionately to the increased earnings before interest and tax depends on the profitability of investment proposals. If the rate of return on investment exceeds their explicit cost financial leverage is said to be positive. However, the determination of optimal level of debt is a formidable task and is a major policy decision. Determination of optimal level of debt involves equalizing between return and risk. Though, there are a number of approaches to determine the level of debt, they cannot be considered as satisfactory and as such can serve only as a guideline. Whatever approaches may be followed for determining the optimal level of debt, the objective of maximising share price should be borne in mind.


What is Multiple Internal Rate of Return?

In cases where project cash flows change signs or reverse during the life of a project e.g. an initial cash outflow is followed by cash inflows and subsequently followed by a major cash outflow , there may be more than one IRR.

What do you mean by Annuity and Perpetuity?

An annuity is a stream of regular periodic payments made or received for a specified period of time. A recurring deposit with the bank is a typical example of an annuity. The interest rate remains the same through out the period of cash flows. Perpetuity is a stream of payments or a type of annuity that starts payment on a fixed date and such payments continue forever or perpetually. Often preferred stock which pays a dividend is considered as a form of perpetuity. Perpetuity is an annuity in which the periodic payments begin on a fixed date and continue indefinitely.

Fund Flow Statement Vs. Cash Flow Statement

Funds flow statement is based on the accrual accounting system. Here only those transactions are considered which are affecting cash or cash equivalents. It analyses the sources and application of funds of long-term nature and the net increase or decrease in long-term funds will be reflected on the working capital of the firm. The cash flow statement will only consider the increase or decrease in current assets and current liabilities in calculating the cash flow of funds from operations.

Funds flow analysis is more useful for long range financial planning, whereas cash flow analysis is more useful for identifying and correcting the current liquidity problems of the firm. Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statement starts with the opening balance of cash and reach to the closing balance of cash by proceeding through sources and uses.

Weighted Average Cost of Capital (WACC) Vs Marginal Cost of Capital

WACC is the weighted average after tax costs of the individual components of firm’s capital structure. That is, the after tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital. The cost of weighted average method is preferred because the proportions of various sources of funds in the capital structure are different. It is of use in two major areas: in considering the firm's position and in evaluation of proposed changes necessitating a change in the firm's capital.

The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the capital is raised in substantial amount in practice marginal cost is referred to as the cost incurred in raising new funds. It is derived when the average cost of capital is calculated using the marginal weights. The marginal weights represent the proportion of funds the firm intends to employ. To calculate it, the intended financing proportion should be applied as weights to marginal component costs. It should, therefore, be calculated in the composite sense.


Concentration Banking and Lock Box System

In concentration banking the company establishes a number of strategic collection centres in different regions instead of a single collection centre at the head office. This system reduces the period between the time a customer mails in his remittances and the time when they become spendable funds with the company. Payments received by the different collection centers are deposited with their respective local banks which in turn transfer all surplus funds to the concentration bank of head office. The concentration bank with which the company has its major bank account is generally located at the headquarters.
Concentration banking is one important and popular way of reducing the size of the float.

Another means to accelerate the flow of funds is a lock box system. While in concentration banking, remittances are received by a collection centre and deposited in the bank after processing, the purpose of lock box system is to eliminate the time between the receipt of remittances by the company and deposit in the bank. A lock box arrangement usually is on regional basis which a company chooses according to its billing patterns.

Cash Credit and Bank Overdraft

Cash credit is a service extended by the banker to its customers by giving a certain amount of credit facility on continuous basis. The borrower will not be allowed to exceed the limits sanctioned by the bank. He is not required to borrow the entire sanctioned amount at once. Rather he can draw periodically to the extent of his requirements and interest is payable on the amount actually utilized.

Bank overdraft is a short-term borrowing facility made available to the companies in case of urgent need of funds. A borrower is allowed to withdraw fund in excess of the balance in his current account up to a specified limit during a stipulated period. The banks issue overdrafts with a right to call them in at short notice.