INTRODUCTION

Finance is the life blood of an organization – Warren

Buffet

2
What is Finance?

 Suppose you want to start up a business. No matter what

the nature of the proposed business is, its size or how it
will be registered, you will have to address some
fundamental questions:
 How much investment is required to set up the business? It
includes preliminary expenditure, land and building, plant
and machinery, and furniture and fixture.
 How will you raise the money? It includes long term
sources like equity and debt.
 How will you finance your day-to-day activities? It includes
your inventory, giving credit to customers, and some cash
to take care of daily operations.
 All this involves finance. 3
What is Financial Management?

 While these are not the only areas of financial decision

making, they are certainly the important ones.
 Financial Management refers to the efficient and
effective utilization of finance (referred to as funds) in
such a manner so as to accomplish the objectives of the
organization.
 It broadly involves two aspects - managing inflow and
outflow of funds.
 As a financial manager you broadly try to pre-pone your
inflows and post-pone your outflows.
 As a finance manager you also need to make a risk –
return trade off in every financial decision because of
4
agency problems.
What is Financial Accounting?

 Financial accounting is basically the backbone of any

financial management system.
 Without proper financial accounting records, finance
managers will not be in a position to take financial
management decisions.
 Financial accounting is basically a process in which
financial transactions are condensed and classified and
recorded and summarized in the books of accounts based
on certain established principles to prepare the Income
statement and Balance sheet.
 Management accounting uses this output to prepare
certain advanced MIS reports (e.g. fund flow statement,
ratio analyses) to aid in financial decision m
5 aking.
Why do we need financial accounting?

 It assists in financial decision making.

 It enables the organization to keep systematic records and
track the assets and liabilities of the organization.
 It prevents chances of error or fraud in the form of revenue
and cost leakages.
 It enables the assessment of liabilities towards direct (Income
tax) and indirect taxes (Excise duty and Sales tax) and
facilitates the filing of returns to tax authorities.
 It ensures transparency to major stakeholders.
 It enables the management to assess the periodical health of
the organization.
 It helps prevent asset liability mismatch (ALM).6
Financial Accounting Vs Financial Management

 Users of Information : External – Internal

 Type of Analysis : Whole – Part
 Data Used : Raw Data – Semi finished Data
 Nature of Analysis : Historical – Futuristic
 Unit of Measurement : Quantitative – Qualitative
 Frequency : Medium to Long Term – Short Term
 Nature : Objective – Subjective
 Precision : Very High – Low to Medium
 Legal Compulsion : Very High – Low
 Nature of Content : Low to Medium – Very High
 Level of Management : Low – Medium to High 7
Economics Vs Financial Management

 The macro economic environment defines the setting

within which a firm operates, and undermines the
conceptual underpinnings for financial decision making.
 The key macro economic variables that influences a
firms objectives are – inflation and interest rates.
 A firms top-lines, bottom-lines, including share prices
are largely influenced by these two factors.
 Other key macro economic factors that influences a firm
are – economic growth rate, tax environment, currency
stability, money supply, supply of skilled man power,
govt policy on land acquisition, etc.
 Without understanding of economics, financial decisions
become irrelevant redundant. 8
Important areas of financial decisions

 Capital Budgeting – The process of analyzing, appraising

and taking decisions with regards to investments in new
projects or businesses or scaling up existing businesses in
the form of increasing existing capacities.
 Working Capital Management – It involves the
assessment of requirement of funds for carrying on the
day to day activities of the businesses, followed by
effective monitoring and control.
 Investment Management – It involves the systematic
allocation of working capital rendered surplus during off
seasons and ploughing back of the same during peak
seasons based on established principles of risk and return
and diversification. 9
Important areas of financial decisions
(contd)

 Capital Structure – It involves decisions regarding the

composition or mix of raising of long term funds from
equity shares – preference shares – debentures.
 Dividend Policy – It refers to establishing patterns in
dividend payment decisions of a firm to its equity
shareholders based on its goals and objectives.

10
Evolution of financial management

 The treatise of ‘Arthashashtra’ propounded by Chanakya

around circa 300 BC forms the basic back bone of
modern economics and finance.
 Even today it is the basis of good governance and
prudent financial decision making.
 Earliest evidences of modern double entry booking
keeping system dates back to around circa 16th century.
 Development of some of the earliest theories in finance
on valuation, capital structure, and dividend policy
began in the US in the 1960s.
 In the 1990s onwards with the availability advanced
computing systems and e-databases, has made possible a
lot of research on risk analysis and its miti11gation.
Objectives of financial management

 Profit Maximization – The most traditional school of

thought in finance argues that a business entity exists for
the sole purpose of making profits and not charity.
Therefore profit maximization is the main objective of
finance.
 Critique: Profit generally implies the surplus of revenue
over cash. However, profits can also be earned by selling
of fixed assets like land, investments held by a firm or
through other sources like interests and dividends on
investments or commissions.
 Such non-orthodox sources of generating profit does not
in any way enhance the health of the organization as they
are not regular sources nor primary to its business.
 Profit is also not well defined and vague. 12
Objectives of financial management (contd)

 Shareholder Wealth Maximization – According to this

school of thought since the equity shareholders provide
seed capital and are the ultimate risk bearers of the firm,
therefore financial decisions should be taken in a manner
that enhances equity share prices as the profits
ultimately belongs to the shareholders.
 Critique: The capital market skeptics argue that the stock
market displays myopic tendencies and are often
incorrectly priced.
 Some argue that other important stakeholders are ignored
like employees, suppliers, customers, etc.
 Most importantly, it ignores the society at large, as a firm
cannot exist in vacuum. 13
Objectives of financial management (end)

 Stakeholder Wealth Maximization – According to this

modern school of thought financial decisions should be
taken in a way to ensure not only the equity
shareholders, but all relevant stakeholders are
benefitted from it. The logic is while shareholders
provide only the risk capital, other stakeholders also
contribute largely to the success of any firm.
 Critique: Balancing the interests of all the relevant
stakeholders is not practical. There is no way to
determine the right balance and will be left to individual
discretion.
 Further, if a firms social objectives supersedes its
business objectives, it will fail to rival its competitors
14
and ultimately become sick.
What then is the right objective?

 Growth – It primarily refers to the extent the firm has

created or enhanced value over a period of time. Growth
can be measured in terms of sales, profits, earnings per
share, market capitalization, etc. Modern organizations
link growth with market leadership and sustainability.
 The broad objective is to grow at pace that outsmarts its
competitors.
 Growth based on one measure is extremely susceptible to
risk.
 Growth will not only ensure healthy profits but will also
maximize returns to shareholders and also contribute to
the society as a whole through CSR.
 Growth therefore reins supreme over all o1b5 jectives.
How to choose organization form?

 An organization is an artificial person. Therefore,

choosing the type of organizational form is important as it
has serious financial implications, especially from the
point of view of finance, taxation and control.
 Sole Proprietorship – It is a business entity owned by a
single person and is subject to minimal government
regulations. It is simple, very easy to set up and set up
costs are nominal. The owner bears all the profits and
losses of the firm. Owners liabilities are unlimited.
 Such firms have limited ability to raise capital and attract
talent.
 It is relatively easy to transfer the assets and or sell of
the firm. 16
Partnership firm

 Partnership – A partnership firm requires a minimum of 2 (two)

members to be set up and can have at the most 20 members
(except in the case of NBFCs 10 members).
 It is governed by the Indian Partnership Act, 1932. Government
regulations are slightly more complex and set up costs are on
the incremental side.
 The partners share all the profits and losses of the firm.
Partners liabilities are unlimited individually and collectively.
 Partnership firms have somewhat greater ability to raise
capital, however attracting talent remains status quo.
 It is the firm which owns the assets therefore, It is relatively
difficult to transfer the assets or sell of the firm.
17
A Company

 Company – It is registered under the Indian Companies

Act, 1956 (as revised 2013). A private company can at the
most have 50 shareholders, while for public company
there is no limit to the no. of shareholders.
 Government regulations are very complex and set up
costs are also very high.
 Public ltd Cos are regulated by SEBI.
 The shareholders share all the profits and losses of the
firm however, their liabilities are limited.
 A company has unlimited potential to raise capital, and
can also attract the brightest talent in the industry.
 It is the firm which owns the assets therefore, It is very
difficult to transfer the assets and or sell of the firm.
 Stakeholders can also sue for winding up.
18
Other issues in selecting organizational form

 Decision Making – In proprietorship firms decision making

is the fastest. In a partnership firm the consent of all the
partners is essential (except for sleeping partners).
Therefore, decision making process slows down. In a
company, since superiors need to ratify decisions, often
at multiple levels; decision making is the slowest.
 Confidentiality – In a proprietorship firm information is
shared with no one, therefore confidentiality is very high.
In case of a partnership firm, confidentiality comes down.
Since company’s need to file their financial details with
RoC and stock exchanges, a lot of information is there in
the public domain.
 Succession Planning – It is the smoothest in case of a
company. 19
Agency problem

 In proprietorship or partnership it is the owners or partners who

also manages the activities of the business entity.
 However, in case of a company there is complete divorce
between ownership (or principal) and management.
 Professional managers are usually appointed to manage the day
to day affairs of the business. There is an implicit relationship
of trust.
 It is expected that the decisions taken by the managers (or
agents) should be well aligned with the dictum of the owners.
However, often there is a conflict between the two. This is
known as agency problem.
 Agency problem needs to minimized through a holistic and 360
degree appraisal of their performance and rewards.
20
The finance vertical (contd)

 Entry Level (0 – 5 yrs) : In industry, entry level finance

functions typically involves around managing working
capital, which includes inventory, debtors and cash. In a
bank it could include: credit appraisal, credit monitoring
and control. In an IT or consulting positions it could
include financial or investment analysis.
 Mid Level (5 – 15 yrs): In industry, mid level finance
functions typically involves investment or treasury
management or may be heading a particular division or
even SBU. In such cases projects appraisal or capital
budgeting, including raising long term finance (advisory
capacity) becomes an important function. In a bank it
could include an operations or branch head. In IT industry
it could be a Sr Consultant.
21
The finance vertical (end)

 Senior Level (15 – above yrs) : In industry, senior level

finance functions (CFO) typically involves designing of
capital structure and dividend policy. As the CFO is
primarily responsible for RoI he also is final approving
authority for new projects or scaling up existing
businesses.
 In a bank it could include senior positions at regional –
zonal – head office levels, where decisions are taken with
regards to exposures in different industries, base rate
across different lending products and opening of new
branches or ATMs.
 In IT / Consulting industry it could be of Country or
Functional heads, directly reporting to the22 BoD.
Chapter - 2

Concepts of Value
and Return
 Chapter Objectives
 Understand what gives money its time value.
 Explain the methods of calculating present
and future values.
 Highlight the use of present value technique
(discounting) in financial decisions.
 Introduce the concept of internal rate of
return.

2
Financial Management, Ninth
 Time Preference for Money
 Time preference for money is an
individual’s preference for possession of a
given amount of money now, rather than the
same amount at some future time.
 Three reasons may be attributed to the
individual’s time preference for money:
 risk
 preference for consumption
 investment opportunities

3
Financial Management, Ninth
 Required Rate of Return
 The time preference for money is generally
expressed by an interest rate. This rate will be
positive even in the absence of any risk. It may
be therefore called the risk-free rate.
 An investor requires compensation for assuming
risk, which is called risk premium.
 The investor’s required rate of return is:
Risk-free rate + Risk premium.

4
Financial Management, Ninth
 Time Value Adjustment

 Two most common methods of adjusting

cash flows for time value of money:
 Compounding—the process of calculating future
values of cash flows and
 Discounting—the process of calculating present
values of cash flows.

5
Financial Management, Ninth
 Future Value
 Compounding is the process of finding the future
values of cash flows by applying the concept of
compound interest.
 Compound interest is the interest that is received on
the original amount (principal) as well as on any
interest earned but not withdrawn during earlier
periods.
 Simple interest is the interest that is calculated only
on the original amount (principal), and thus, no
compounding of interest takes place.

6
Financial Management, Ninth
 Future Value
 The general form of equation for calculating
the future value of a lump sum after n periods
may, therefore, be written as follows:
F n  P(1  i ) n
 The term (1 + i)n is the compound value
factor (CVF) of a lump sum of Re 1, and it
always has a value greater than 1 for positive
i, indicating that CVF increases as i and n
increase.
Fn =P  CVFn,i
7
Financial Management, Ninth
 Example
 If you deposited Rs 55,650 in a bank, which
was paying a 15 per cent rate of interest on a
ten-year time deposit, how much would the
deposit grow at the end of ten years?

 We will first find out the compound value

factor at 15 per cent for 10 years which is
4.046. Multiplying 4.046 by Rs 55,650, we get
Rs 225,159.90 as the compound value:
FV  55,650 × CVF10, 0.12  55,650  4.046  Rs 225,159.90

8
Financial Management, Ninth
 Future Value of an Annuity
 Annuity is a fixed payment (or receipt) each
year for a specified number of years. If you rent
a flat and promise to make a series of
payments over an agreed period, you have
created an annuity.
 (1 i)n 1 
Fn  A  
 i 
 The term within brackets is the compound
value factor for an annuity of Re 1, which we
shall refer as CVFA.
Fn =A CVFAn,i
9
Financial Management, Ninth
 Example
 Suppose that a firm deposits Rs 5,000 at the
end of each year for four years at 6 per cent
rate of interest. How much would this annuity
accumulate at the end of the fourth year? We
first find CVFA which is 4.3746. If we multiply
4.375 by Rs 5,000, we obtain a compound
value of Rs 21,875:
F4  5,000(CVFA4, 0.06 )  5,000  4.3746  Rs 21,873

10
Financial Management, Ninth
Sinking Fund
 Sinking fund is a fund, which is created out of
fixed payments each period to accumulate to a
future sum after a specified period. For
example, companies generally create sinking
funds to retire bonds (debentures) on maturity.
 The factor used to calculate the annuity for a
given future sum is called the sinking fund
factor (SFF).
 i 
A = Fn  
 (1 i) n
1 
11
Financial Management, Ninth
 Present Value
 Present value of a future cash flow (inflow or
outflow) is the amount of current cash that is
of equivalent value to the decision-maker.
 Discounting is the process of determining
present value of a series of future cash flows.
 The interest rate used for discounting cash
flows is also called the discount rate.

12
Financial Management, Ninth
Present Value of a Single Cash Flow
 The following general formula can be employed to
calculate the present value of a lump sum to be
received after some future periods:
Fn
P n
 Fn

 (1 i) n


(1 i)
 The term in parentheses is the discount factor or
present value factor (PVF), and it is always less
than 1.0 for positive i, indicating that a future amount
has a smaller present value.

PV  Fn  PVFn,i

13
Financial Management, Ninth
 Example
 Suppose that an investor wants to find out
the present value of Rs 50,000 to be
received after 15 years. Her interest rate is
9 per cent. First, we will find out the present
value factor, which is 0.275. Multiplying
0.275 by Rs 50,000, we obtain Rs 13,750 as
the present value:
PV = 50,000  PVF15, 0.09 = 50,000  0.275 = Rs 13,750

14
Financial Management, Ninth
 Present Value of an Annuity
 The computation of the present value of an
annuity can be written in the following general
form:
1 1 
P  A  n 
i i 1 i  

 The term within parentheses is the present

value factor of an annuity of Re 1, which we
would call PVFA, and it is a sum of single-
payment present value factors.
P = A × PVAFn,i

15
Financial Management, Ninth
 Capital Recovery and Loan
Amortisation
 Capital recovery is the annuity of an investment
made today for a specified period of time at a
given rate of interest. Capital recovery factor
helps in the preparation of a loan amortisation
(loan repayment) schedule.
 1 
A= P 
 PVAFn,i 

A = P × CRFn,i
The reciprocal of the present value annuity factor
is called the capital recovery factor (CRF).

16
Financial Management, Ninth
Present Value of an Uneven Periodic
Sum
 Investments made by of a firm do not
frequently yield constant periodic cash flows
(annuity). In most instances the firm receives
a stream of uneven cash flows. Thus the
present value factors for an annuity cannot be
used. The procedure is to calculate the
present value of each cash flow and
aggregate all present values.

17
Financial Management, Ninth
 Present Value of Perpetuity
 Perpetuity is an annuity that occurs
indefinitely. Perpetuities are not very common
in financial decision-making:
Perpetuity
Present value of a perpetuity 
Interest rate

18
Financial Management, Ninth
 Present Value of Growing Annuities
 The present value of a constantly growing
annuity is given below:
 
P = A 1  1 g 
n

i  g   1 i  
 Present value of a constantly growing
perpetuity is given by a simple formula as
follows:

A
P=
i–g

19
Financial Management, Ninth
 Value of an Annuity Due
 Annuity due is a series of fixed receipts or
payments starting at the beginning of each
period for a specified number of periods.
 Future Value of an Annuity Due
Fn = A  CVFAn,i × (1 i)
 Present Value of an Annuity Due
P = A × PVFAn, i × (1 + i)

20
Financial Management, Ninth
 Multi-PeriodCompounding
 If compounding is done more than once a
year, the actual annualised rate of interest
would be higher than the nominal interest rate
and it is called the effective interest rate.

nm
 i
EIR = 1  – 1
 m

21
Financial Management, Ninth
 Continuous Compounding
 The continuous compounding function takes
the form of the following formula:
Fn  P  ei n  P  ex
 Present value under continuous compounding:

Fn  F × ei n
P n
ei n

22
Financial Management, Ninth
 Net Present Value
 Net present value (NPV) of a financial
decision is the difference between the present
value of cash inflows and the present value of
cash outflows.
n

NPV = 
Ct
t
 C0
t 1 (1 + k)

23
Financial Management, Ninth
 Present Value and Rate of Return
 A bond that pays some specified amount in
future (without periodic interest) in exchange for
the current price today is called a zero-interest
bond or zero-coupon bond. In such situations,
you would be interested to know what rate of
interest the advertiser is offering. You can use
the concept of present value to find out the rate
of return or yield of these offers.
 The rate of return of an investment is called
internal rate of return since it depends
exclusively on the cash flows of the investment.
24
Financial Management, Ninth
 Internal Rate of Return
 The formula for Internal Rate of Return is
given below. Here, all parameters are given
except ‘r’ which can be found by trial and
error.
n

NPV = 
Ct
t
 C0  0
t 1 (1 + r)

25
Financial Management, Ninth
Chapter - 3

Valuation of Bonds and Shares

 Chapter Objectives
 Explain the fundamental characteristics of
ordinary shares, preference shares and bonds
(or debentures).
 Show the use of the present value concepts in
the valuation of shares and bonds.
 Learn about the linkage between the share
values, earnings and dividends and the
required rate of return on the share.
 Focus on the uses and misuses of price-
earnings (P/E) ratio.

2
Financial Management, Ninth
 Introduction
 Assets can be real or financial; securities like
shares and bonds are called financial assets
while physical assets like plant and
machinery are called real assets.
 The concepts of return and risk, as the
determinants of value, are as fundamental
and valid to the valuation of securities as to
that of physical assets.

3
Financial Management, Ninth
 Concept of Value
 Book Value
 Replacement Value
 Liquidation Value
 Going Concern Value
 Market Value

4
Financial Management, Ninth
 Features of a Bond
 Face Value
 Interest Rate—fixed or floating
 Maturity
 Redemption value
 Market Value

5
Financial Management, Ninth
Bonds Values and Yields
 Bonds with maturity
 Pure discount bonds
 Perpetual bonds

6
Financial Management, Ninth
 Bond with Maturity
Bond value = Present value of interest + Present
value of maturity value:
n
INTt Bn
B0   
t 1 (1 kd )t (1 kd )n

7
Financial Management, Ninth
 Yield to Maturity
 The yield-to-maturity (YTM) is the measure
of a bond’s rate of return that considers both
the interest income and any capital gain or
loss. YTM is bond’s internal rate of return.
 A perpetual bond’s yield-to-maturity:
n
INT INT
B0   t

t 1 (1 kd ) kd

8
Financial Management, Ninth
Current Yield
 Current yield is the annual interest divided bythe
bond’s current value.
 Example: The annual interest is Rs 60 on the
current investment of Rs 883.40. Therefore, the
current rate of return or the current yield is:
60/883.40 = 6.8 per cent.
 Current yield does not account for the capital gain
or loss.

9
Financial Management, Ninth
Yield to Call
 For calculating the yield to call, the call period
would be different from the maturity period and
the call (or redemption) value could be different
from the maturity value.
 Example: Suppose the 10% 10-year Rs 1,000
bond is redeemable (callable) in 5 years at a call
price of Rs 1,050. The bond is currently selling
for Rs 950.The bond’s yield to call is 12.7%.
5

950  
100 1,050

t 1 1 YTC t 1 YTC 5

10
Financial Management, Ninth
Bond Value and Amortisation of
Principal
 A bond (debenture) may be amortised every
year, i.e., repayment of principal every year
rather at maturity.
 The formula for determining the value of a bond
or debenture that is amortised every year, can
be written as follows:
n
CFt
B0   t
t 1 (1 kd )

 Note that cash flow, CF, includes both the interest

and repayment of the principal.
11
Financial Management, Ninth
 Pure Discount Bonds
 Pure discount bond do not carry an explicit
rate of interest. It provides for the payment of a
lump sum amount at a future date in exchange
for the current price of the bond. The difference
between the face value of the bond and its
purchase price gives the return or YTM to the
investor.

12
Financial Management, Ninth
 Pure Discount Bonds
 Example: A company may issue a pure
discount bond of Rs 1,000 face value for
Rs 520 today for a period of five years.
The rate of interest can be calculated as
follows:
1,000
520 
1 YTM 5
1 YTM 5 
1,000
 1.9231
520
i  1.92311/5 1  0.14 or 14%

13
Financial Management, Ninth
 Pure Discount Bonds
 Pure discount bonds are called deep-
discount bonds or zero-interest bonds or
zero-coupon bonds.
 The market interest rate, also called the
market yield, is used as the discount rate.
 Value of a pure discount bond = PV of the
amount on maturity:
Mn
B0 
1 kd n

14
Financial Management, Ninth
 Perpetual Bonds
 Perpetual bonds, also called consols, has an
indefinite life and therefore, it has no maturity
value. Perpetual bonds or debentures are rarely
found in practice.

15
Financial Management, Ninth
 Perpetual Bonds
 Suppose that a 10 per cent Rs 1,000 bond will
pay Rs 100 annual interest into perpetuity. What
would be its value of the bond if the market yield
or interest rate were 15 per cent?
 The value of the bond is determined as follows:
INT 100
B0    Rs 667
kd 0.15

16
Financial Management, Ninth
 Bond Values and Changes in
Interest Rates
 The value of the bond
declines as the market
interest rate (discount 1200.0
rate) increases. 1000.0

 The value of a 10-year, 800.0

BondValue
12 per cent Rs 1,000 600.0

bond for the market 400.0

interest rates ranging 200.0

from 0 per cent to 0.0

0% 5% 10% 15% 20% 25% 30%
30 per cent. Interest Rate

17
Financial Management, Ninth
 Bond Maturity and Interest Rate
Risk
 The intensity of interest rate
risk would be higher on
bonds with long maturities
than bonds with short
maturities. PresentValue(Rs)
Discountrate(%) 5-Yearbond 10-Yearbond Perpetualbond
 The differential value 5 1,216 1,386 2,000
response to interest rates 10 1,000 1,000 1,000
changes between short and 15 832 749 667
long-term bonds will always
be true. Thus, two bonds of 20 701 581 500
same quality (in terms of the 25 597 464 400
risk of default) would have 30 513 382 333
different exposure to
interest rate risk.

18
Financial Management, Ninth
Bond Maturity and Interest Rate
Risk
2000
5-year bond
1750 10-year bond
1500 Perpetual bond
Value (Rs)

1250
1000
750
500
250
0
5 10 15 20 25 30
Discount rate (%)

19
Financial Management, Ninth
 Bond Durationand Interest
Rate Sensitivity
 The longer the maturity of a bond, the higher
will be its sensitivity to the interest rate
changes. Similarly, the price of a bond with
low coupon rate will be more sensitive to the
interest rate changes.
 However, the bond’s price sensitivity can be
more accurately estimated by its duration. A
bond’s duration is measured as the weighted
average of times to each cash flow (interest
payment or repayment of principal).
20
Financial Management, Ninth
 Durationof Bonds
 Let us consider the
8.5 per cent rate bond 8.5 Percent Bond
of Rs 1,000 face Year Cash Flow
Present Value
at 10 %
Proportion of
Bond Price
Proportion of
Bond Price x Time
value that has a 1 85 77.27 0.082 0.082
2 85 70.25 0.074 0.149
current market value 3 85 63.86 0.068 0.203
4 85 58.06 0.062 0.246
of Rs 954.74 and a 5 1,085 673.70 0.714 3.572
943.14 1.000 4.252
YTM of 10 per cent, 11.5 Percent Bond

and the 12 per cent Year

Cash
Flow
Present Value
at 10.2%
Proportion of
Bond Price
Proportion of Bond
Price x Time

rate bond of Rs 1,000 1

2
115
115
103.98
94.01
0.101
0.091
0.101
0.182
face value has a 3
4
115
115
85.00
76.86
0.082
0.074
0.247
0.297
current market value 5 1,115 673.75 0.652 3.259
1,033.60 1.000 4.086
of Rs 1,044.57 and a
yield to maturity of
10.8 per cent. Table
shows the calculation
of duration for the two
bonds.
21
Financial Management, Ninth
Volatility
 The volatility or the interest rate sensitivity of a bond
is given by its duration and YTM. A bond’s volatility,
referred to as its modified duration, is given as
follows:
Duration
Volatility of a bond 
(1 YTM)
 The volatilities of the 8.5 per cent and 11.5 per cent
bonds are as follows:
4.252
Volatility of 8.5% bond   3.87
(1.100)
4.086
Volatility of 11.5% bond   3.69
(1.106)
22
Financial Management, Ninth
 The Term Structure of Interest
Rates
 Yield curve shows the relationship between the
yields to maturity of bonds and their maturities. It is
also called the term structure of interest rates.
 Yield Curve (Government of India Bonds)

Yield (%)
7.5%
7.18%
7.0%

6.5%

6.0%
5.90%
5.5%
Maturity
5.0% (Years )
0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10

23
Financial Management, Ninth
The Term Structure of Interest Rates
 The upward sloping yield curve implies that
the long-term yields are higher than the short-
term yields. This is the normal shape of the
yield curve, which is generally verified by
historical evidence.
 However, many economies in high-inflation
periods have witnessed the short-term yields
being higher than the long-term yields. The
inverted yield curves result when the short-
term rates are higher than the long-term
rates.
24
Financial Management, Ninth
 The Expectation Theory
 The expectation theory supports the upward
sloping yield curve since investors always
expect the short-term rates to increase in the
future.
 This implies that the long-term rates will be
higher than the short-term rates.
 But in the present value terms, the return
from investing in a long-term security will
equal to the return from investing in a series
of a short-term security.

25
Financial Management, Ninth
 The Expectation Theory
 The expectation theory assumes
 capital markets are efficient
 there are no transaction costs and
 investors’ sole purpose is to maximize their returns
 The long-term rates are geometric average of current
and expected short-term rates.
 A significant implication of the expectation theory is
that given their investment horizon, investors will earn
the same average expected returns on all maturity
combinations.
 Hence, a firm will not be able to lower its interest cost
in the long-run by the maturity structure of its debt.

26
Financial Management, Ninth
 The Liquidity Premium Theory
 Long-term bonds are more sensitive than the
prices of the short-term bonds to the changes
in the market rates of interest.
 Hence, investors prefer short-term bonds to
the long-term bonds.
 The investors will be compensated for this risk
by offering higher returns on long-term bonds.
 This extra return, which is called liquidity
premium, gives the yield curve its upward
bias.

27
Financial Management, Ninth
 The Liquidity Premium
Theory
 The liquidity premium theory means that rates
on long-term bonds will be higher than on the
short-term bonds.
 From a firm’s point of view, the liquidity
premium theory suggests that as the cost of
short-term debt is less, the firm could
minimize the cost of its borrowings by
continuously refinancing its short-term debt
rather taking on long-term debt.

28
Financial Management, Ninth
 The Segmented Markets
Theory
 The segmented markets theory assumes that
the debt market is divided into several
segments based on the maturity of debt.
 In each segment, the yield of debt depends
on the demand and supply.
 Investors’ preferences of each segment arise
because they want to match the maturities of
assets and liabilities to reduce the
susceptibility to interest rate changes.

29
Financial Management, Ninth
 The Segmented Markets
Theory
 The segmented markets theory approach
assumes investors do not shift from one
maturity to another in their borrowing—lending
activities and therefore, the shift in yields are
caused by changes in the demand and supply
for bonds of different maturities.

30
Financial Management, Ninth
 Default Risk and Credit Rating
 Default risk is the risk that a company will
default on its promised obligations to
bondholders.
 Default premium is the spread between the
promised return on a corporate bond and the
return on a government bond with same
maturity.

31
Financial Management, Ninth
 Crisil’s Debenture Ratings
H i g h I nv e s t me nt G r a d e s
A A A (Triple A ) : H i g h e s t S a fety D e b e n t u r e s rated ` A A A ' are j u d g e d t o offer h i g h e s t sa f e t y o f
timely p a y m e n t of interest a n d principal. T h o u g h t h e
circu m s t a n c e s p r o v i d i n g this d e g r e e o f safety are like ly to
c h a n g e , s u c h c h a n g e s as c a n b e e n v i s a g e d are m o s t unlik ely to
a f f e c t a d v e r s e l y t h e f u n d a m e n t a l l y s t r o n g p o s i t i o n o f s u c h iss u e s .
A A ( D o u b l e A ) : H i g h S a fety D e b e n t u r e s ra t e d ' A A ' a re j u d g e d t o offe r h i g h sa f e t y o f t i me ly
p a y m e n t o f interest a n d principal. T h e y differ in sa f e t y fro m
` A A A ' i s s u e s o n l y m a r g i n a lly.
I n ves t m e n t G r a d e s
A : A d e q u a t e S a fety D e b e n t u r e s ra t e d ` A ' a re j u d g e d t o offe r a d e q u a t e sa fe t y o f t i me ly
p a y m e n t o f interest a n d principal; h o w e v e r , c h a n g e s in
circu m s t a n c e s c a n a d v e r se l y affect s u c h i ssues m o r e t h a n t h o s e in
t h e h i g h e r rated c a t e g o r i e s .
B B B ( T rip le B ) : M o d e r a t e Safety D e b e n t u r e s ra ted ` B B B ' are j u d g e d to offer sufficient s a f et y o f
timely p a y m e n t o f interest a n d principal for t h e p r e se n t ; h o w e v e r ,
c h a n g i n g c i r c u ms t a n c e s are m o r e like ly t o lead to a w e a k e n e d
c a p a c i t y to p a y interest a n d r e p a y p rin c ipal t h a n for d e b e n t u r e s in
h i g h e r rat ed categories.
S peculat i ve G r a d e s
B B ( D o u b l e B ) : I n a d e q u a t e S a fety D e b e n t u r e s r ate d ` B B ' a re j u d g e d t o c arr y i na d e q u a t e s a fe ty o f
timely p a y m e n t o f intere st a n d pri nc ipal ; w h ile t h e y are less
su sc e p ti b le t o d e fa ult t h a n o t h e r sp e c u l a ti v e g r a d e d e b e n t u r e s in
t h e i m m e d i a t e f u t u r e , t h e u n c e r t a i n t i e s t h a t t h e is s u e r f a c e s c o u l d
lead to i n a d e q u a t e c a p a c i t y to m a k e t ime l y interest a n d principal
p a y m e n t s .
B : H i g h Risk D e b e n t u r e s rated `B' are j u d g e d t o h a v e gr e a t e r susceptibility t o
d efault ; while currently interest a n d principal p a y m e n t s are met,
a d v e r s e b u si n e s s o r e c o n o m i c c o n d i t i o n s w o u l d lead t o lack o f
ability o r wi l l i n g n e s s to p a y interest o r principal.
C: S u b s t a n t i a l Risk D e b e n t u r e s rated `C' are j u d g e d to h a v e factors p r e se n t that m a k e
t h e m v u l n e r a b l e t o default ; time ly p a y m e n t o f interes t a n d
p r i n c i p a l is p o s s ible o n l y if f a v o u r a b l e c i rc u m s t a n c e s c o n t i n u e .
D : In D e f a u l t D e b e n t u r e s rated `B' are j u d g e d t o h a v e g r e a t e r susceptibility t o
d efault ; whi le c u r re ntl y intere st a n d p r incip al p a y m e n t s are met,
a d v e r s e b u si n e s s o r e c o n o m i c c o n d i t i o n s w o u l d lead t o lack o f
ability o r wi l l i n g n e s s to p a y interest o r principal.
N o t e :
1. C R I S I L m a y a p p l y " + " ( p l u s ) o r " -" ( m i n u s ) s i g n s f o r r a t i n g s f r o m A A to D to reflect c o m p a r a t i v e standing
within t h e category.
2. T h e contents within parenthesi s a r e a g u i d e to the p r o n u n c i a tion of the rating s y m bo l s .
3. Pr e f e r e n c e s h a r e rating s y m b o l s a r e identical to d e be n t u r e rating s y m b o l s except that th e letters " pf" a r e
prefixed to th e d e b e n t u r e r a t i n g s y m b o l s , e.g. p f A A A (" p f Trip le A" ) .

32
Financial Management, Ninth
 Valuation of Shares
 A company may issue two types of shares:
 ordinary shares and
 preference shares

 Features of Preference and Ordinary Shares

 Claims
 Dividend
 Redemption
 Conversion

33
Financial Management, Ninth
 Valuation of Preference Shares
 The value of the preference share would be
the sum of the present values of dividends
and the redemption value.
 A formula similar to the valuation of bond can
be used to value preference shares with a
maturity period:
n
PDIV1 Pn
P0   
t 1 (1 k p ) (1 k p )n
t

34
Financial Management, Ninth
 Value of a Preference Share-Example
Suppose an investor is considering the purchase of a 12-year, 10% Rs 100 par value preference share. The
redemption value of the preference share on maturity is Rs 120. The investor’s required rate of return is
10.5 percent. What should she be willing to pay for the share now? The investor would expect to receive
Rs 10 as preference dividend each year for 12 years and Rs 110 on maturity (i.e., at the end of 12 years). We
can use the present value annuity factor to value the constant stream of preference dividends and the
present value factor to value the redemption payment.

 1 1  120
P0  10   
12 

0.105 0.105 (1.105)  (1.105)12
 10  6.506  120 0.302  65.06  36.24  Rs101.30

Note that the present value of Rs 101.30 is a composite of the present value of dividends, Rs 65.06 and
the present value of the redemption value, Rs 36.24.The Rs 100 preference share is worth Rs 101.3 today
at 10.5 percent required rate of return. The investor would be better off by purchasing the share for Rs 100
today.

35
Financial Management, Ninth
 Valuation of Ordinary Shares
 The valuation of ordinary or equity shares s
i
relatively more difficult.
 The rate of dividend on equity shares is not
known; also, the payment of equity dividend is
discretionary.
 The earnings and dividends on equity shares are
generally expected to grow, unlike the interest on
bonds and preference dividend.

36
Financial Management, Ninth
 Dividend Capitalisation
 The value of an ordinary share is determined
by capitalising the future dividend stream at
the opportunity cost of capital
DIV1  P1

Single Period Valuation: 0 1 k
P
e
 If the share price is expected to grow at g
percent, then P1  P0(1 g)
 We obtain a simple formula for the share valuation
as follows:
DIV1
P0 
ke  g

37
Financial Management, Ninth
 Multi-period Valuation
 If the final period is n, we can write the
general formulan for share value as follows:
DIVt Pn
P0   
t 1 (1 ke )t (1 ke )n
 Growth in Dividends
Growth = Retention ratio Return on equity
g  b  ROE
 Normal Growth
DIV1
P0 
ke  g
 Super-normal Growth
Share value  PV of dividends during finite super-normal growth period
 PV of dividends during indefinite normal growth period
38
Financial Management, Ninth
 Earnings Capitalisation
 Under two cases, the value of the share can
be determined by capitalising the expected
earnings:
 When the firm pays out 100 per cent dividends;
that is, it does not retain any earnings.
 When the firm’s return on equity (ROE) is equal to
its opportunity cost of capital.

39
Financial Management, Ninth
 Equity Capitalisation Rate
 For firms for which dividends are expected to
grow at a constant rate indefinitely and the
current market price is given
DIV1
ke  g
P0

40
Financial Management, Ninth
 Caution in Using Constant-
Growth Formula
 Estimation errors
 Unsustainable high current growth
 Errors in forecasting dividends

41
Financial Management, Ninth
 Valuing Growth Opportunities
 The value of a growth opportunity is given
as follows:
NPV1
Vg 
ke  g
b  EPS1(ROE  ke )

ke (ke  g)

42
Financial Management, Ninth
Price-Earnings (P/E) Ratio: How
Significant?
 P/E ratio is calculated as the price of a share
divided by earning per share.
 Some people use P/E multiplier to value the
shares of companies.
 Alternatively, you could find the share value by
dividing EPS by E/P ratio, which is the
reciprocal of P/E ratio.

43
Financial Management, Ninth
Price-Earnings (P/E) Ratio: How
Significant?
 The share price is also given by the following
formula:
EPS1
P0   Vg
ke
 The earnings price ratio can be derived as
follows:
EPS1  Vg 
 ke 1 
Po  Po 

44
Financial Management, Ninth
Price-Earnings (P/E) Ratio: How
Significant?
 Cautions:
 E/P ratio will be equal to the capitalisation rate
only if the value of growth opportunities is zero.
 A high P/E ratio is considered good but it could
be high not because the share price is high but
because the earnings per share are quite low.
 The interpretation of P/E ratio becomes
meaningless because of the measurement
problems of EPS.

45
Financial Management, Ninth
Chapter - 4

Risk and Return: An

Overview of Capital
Market Theory
 Chapter Objectives
 Discuss the concepts of average and expected rates
of return.
 Define and measure risk for individual assets.
 Show the steps in the calculation of standard
deviation and variance of returns.
 Explain the concept of normal distribution and the
importance of standard deviation.
 Compute historical average return of securities and
market premium.
 Determine the relationship between risk and return.
 Highlight the difference between relevant and
irrelevant risks.

2
Financial Management, Ninth
 Returnon a Single Asset
 Total return Rate of return  Dividend yield  Capital gain yield
= Dividend
DIV1 P1  P0 DIV1  P1  P0 
+ Capital R1   
P0 P0 P0
gain

160.00 149.70
140.00

 Year-to-
120.00
Total Retur

100.00 92.33

80.00 70.54

Year Total 60.00 49.52 52.64

36.13
40.00 22.71
16.52 12.95
20.00 7.29

Returns on 0.00
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

HLL Share Year

3
Financial Management, Ninth
 Average Rate of Return
 The average rate of return is the sum of the
various one-period rates of return divided by
the number of period.
 Formula for the average rate of return is as
follows:
n
1 1
R = [R1  R2  L  R n ] 
n n
R t
t =1

4
Financial Management, Ninth
 Risk of Rates of Return:Variance
and Standard Deviation
 Formulae for calculating variance and
standard deviation:
Standard deviation = Variance
n

  
2
1
 
2
Rt  R
n 1 t 1

5
Financial Management, Ninth
 Investment Worth of Different
Portfolios, 1969–70 to 1997–98
I n d ex

100
Stock Market Return
Call Money Market 57.16
Long-t erm Govt. Bonds
Inflation

91-day TB 13.99
10.36
10 10.20

4.41

1
Year
1982-83

1986-87

1997-98
1969-70

1971-72
1972-73
1973-74

1975-76

1977-78
1978-79
1979-80
1980-81
1981-82

1983-84
1984-85

1988-89
1989-90
1990-91
1991-92
1992-93

1994-95
1995-96
1974-75

1976-77

1985-86

1987-88

1993-94

1996-97
1970-71

6
Financial Management, Ninth
 Averages and Standard
Deviations, 1970–71 to 1997–98
Arithmetic Standard Risk Risk
Securities mean deviation premium * premium #

Ordinary shares (RBI Index) 17.50 22.34 12.04 8.76

Call money market 9.93 3.49 4.47 1.19
Long-term government bonds 8.74 2.59 3.28
91-Day treasury bills 5.46 2.05
Inflation 8.80 5.82

Relative to 91-Days T-bills. # Relative to long-term government bonds.

7
Financial Management, Ninth
 Expected Return : Incorporating
Probabilities in Estimates
 The expected rate of
return [E (R)] is the sum Economic Conditions
(1)
RETURNS UNDER VARIOUS ECONOMIC CONDITIONS
Share Price
(2)
Dividend
(3)
Dividend Yield
(4)
Capital Gain
(5)
Return
(6) = (4) + (5)

of the product of each High growth

Expansion
305.50
285.50
4.00
3.25
0.015
0.012
0.169
0.093
0.185
0.105
Stagnation 261.25 2.50 0.010 0.000 0.010

outcome (return) and its Decline 243.50 2.00 0.008 – 0.068 – 0.060

associated probability:

RETURNS AND PROBABILITIES

Economic Conditions Rate of Return (%) Probability Expected Rate of Return (%)
(1) (2) (3) (4) = (2)  (3)
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline – 6.0 0.25 – 1.50
1.00 6.00

8
Financial Management, Ninth
 Expected Risk and Preference
 The following formula can be used to
calculate the variance of returns:
 2   R1  E R 2  P1   R2  E R 2  P2  ...   Rn  E R 2  Pn

   Ri  E R 2 Pi
n

i1

9
Financial Management, Ninth
 Expected Risk and Preference
 A risk-averse investor will choose among
investments with the equal rates of return, the
investment with lowest standard deviation.
Similarly, if investments have equal risk
(standard deviations), the investor would prefer
the one with higher return.
 A risk-neutral investor does not consider risk,
and would always prefer investments with higher
returns.
 A risk-seeking investor likes investments with
higher risk irrespective of the rates of return. In
reality, most (if not all) investors are risk-averse.
10
Financial Management, Ninth
 Normal Distribution
 Normal distribution is an important concept in
statistics and finance. In explaining the risk-
return relationship, we assume that returns
are normally distributed.
 Normal distribution is a population-based,
theoretical distribution.

11
Financial Management, Ninth
 RATIO ANALYSIS

• Ratio analysis is the process of determining and

interpreting numerical relationship based on financial
statements. It is the technique of interpretation of
financial statements with the help of accounting ratios
derived from the balance sheet and profit and loss
account.
 Basis Of Comparision
Trend Analysis involves comparison of a firm over a
period of time, that is, present ratios are compared with
past ratios for the same firm. It indicates the direction of
change in the performance – improvement, deterioration
or constancy – over the years.
Interfirm Comparison involves comparing the ratios of a
firm with those of others in the same lines of business or
for the industry as a whole. It reflects the firm’s
performance in relation to its competitors.

Comparison with standards or industry average

 Ways To Interpret Accounting
Ratios
Single absolute ratio.
Group ratio.
Historical comparision.
Inter-firm comparision.
Projected ratios.
 Classification Of Ratios
• Analysis of Short Term Financial Position or
Test of Liquidity.
• Analysis of Long Term Financial Position or
Test of Solvency.
• Activity Ratios.
Profitability Ratios.
 I. Test Of Liquidity
The liquidity ratios are used to test the short term
solvency or liquidity position of the business.
It enables to know whether short term liabilities can be
paid out of short term assets.
It indicates whether a firm has adequate working
capital to carry out routine business activity.
It is a valuable aid to management in checking the
efficiency with which working capital is being
employed.
It is also of importance to shareholders and long term
creditors in determining to some extent the prospects
of dividend and interest payment.
 Important Ratios In Test Of
Liquidity
Current ratio.
Quick ratio.
Absolute liquid ratio.
 Current Ratio
It is the most widely used of all analytical devices based
on the balance sheet. It establishes relationship between
total current assets and current liabilities.

Current assets
Current ratio=
Current liabilities

Ideal ratio: 2:1

High ratio indicates under trading and over
capitalization.
Low ratio indicates over trading and under capitalization.
 Quick Ratio or Acid Test Ratio
It establishes relationship between liquid assets and
liquid liabilities. It is a refinement to current ratio and
second testing device for working capital.

Quick assets
Quick ratio=
Current liabilities

Ideal ratio: 1:1

Usually, a high acid test ratio is an indication that the
firm is liquid and has ability to meet its current or liquid
liabilities in time and on the other hand a low quick ratio
represents that the firm’s liquidity position is not good.
 Absolute Liquidity Ratio
This ratio establishes a relationship between absolute
liquid assets to quick liabilities.

Absolute liquid assets

Absolute liquid ratio=
Quick liabilities

Ideal ratio: 1:2

It means that if the ratio is 1:2 or more than this the
concern can be taken as liquid. If the ratio is less than
the standard of 1:2, it means the concern is not liquid.
 II. Test Of Solvency
Long term solvency ratios denote the
ability of the organisation to repay the loan
and interest.
When an organization's assets are more
than its liabilities is known as solvent
organisation.
Solvency indicates that position of an
enterprise where it is capable of meeting
long term obligations.
 Important Ratios In Test Of
Solvency
Debt-equity ratio.
Proprietary ratio.
Solvency ratio.
Fixed assets to net worth ratio.
Current assets to net worth ratio.
Current liabilities to net worth ratio.
Capital gearing ratio.
Fixed assets ratio
Debt servicing ratio.
Dividend coverage ratio.
 Debt Equity Ratio
It Is calculated to measure the relative claims of
outsiders and the owners against the firm’s assets. This
ratio indicates the relationship between the outsiders
funds and the shareholders’ funds.
Outsiders funds
Debt equity ratio=
Shareholders funds
Ideal ratio: 2:1; It means for every 2 shares there is 1
debt. If the debt is less than 2 times the equity, it means
the creditors are relatively less and the financial
structure is sound. If the debt is more than 2 times the
equity, the state of long term creditors are more and
indicate weak financial structure.
 Proprietary Ratio or Net Worth
Ratio
It establishes relationship between the proprietors fund
or shareholders funds and the total assets

Proprietary funds Capital employed

Proprietary ratio= or
Total assets Total liabilities

Ideal ratio: 0.5:1

Higher the ratio better the long term solvency (financial)
position of the company. This ratio indicates the extent
to which the assets of the company can be lost without
affecting the interest of the creditors of the company
 Solvency Ratio
It expresses the relationship between total assets and
total liabilities of a business. This ratio is a small variant
of equity ratio and can be simply calculated as
100-equity ratio
Total assets
Solvency ratio=
Total liabilities
No standard ratio is fixed in this regard. It may be
compared with similar, such organisations to evaluate
the solvency position. Higher the solvency ratio, the
stronger is its financial position and vice-versa.
 Fixed Assets To Net Worth
It is obtained by dividing the depreciated book value of
fixed assets by the amount of proprietors funds.
Net fixed assets
Fixed assets to net worth ratio=
Net worth
Ideal ratio: 0.75:1
A higher ratio, say, 100% means that there are no
outside liabilities and all the funds employed are those of
shareholders. In such a case the return to shareholders
would be lower rate of dividend and this is also a sign of
over capitalization.
 Fixed Assets To Net Worth
This ratio shows the extent to which ownership
funds are sunk into assets with relatively low
turnover. When the amount of proprietor's
funds exceed the value of fixed assets, apart of
the net working capital is provided by the
shareholders, provided there are no other non-
current assets, and when proprietor’s funds are
less than the fixed assets, creditors obligation
have been used to finance a part of fixed
assets. The Yardstick for this measure is 65%
for industrial undertakings.
 Current Assets To Net Worth Ratio
It is obtained by dividing the value of current assets by
the amount of proprietor’s funds. The purpose of this
ratio is to show the percentage of proprietor’s fund
investment in current assets.
Current assets
Current assets to net worth ratio=
Proprietor’s fund
A higher proportion of current assets to proprietor’s fund,
as compared with the proportion of fixed assets to
proprietor’s funds is advocated, as it is an indicator of
the financial strength of the business, depending on the
nature of the business there may be different ratios for
different firms. This ratio must be read along with the
results of fixed assets to proprietor’s funds ratio.
 Current Liabilities To Net Worth
It is expressed as a proportion and is obtained by
dividing current liabilities by proprietor's fund.

Current liabilities
Current liabilities to net worth ratio=
Net worth

Ideal ratio:1:3
This ratio indicates the relative contribution of short term
creditors and owners to the capital of an enterprise. If
the ratio is high, it means it is difficult to obtain long term
funds by the business.
 Capital Gearing Ratio
It expresses the relationship between equity capital and
fixed interest bearing securities and fixed dividend
bearing shares.
Fixed interest bearing securities + fixed dividend
bearing shares
CGR=
Equity shareholders funds
Components of fixed Components of equity
interest bearing securities shareholders funds
Debentures Equity share capital
Long-term loans Accumulated reserves &
Long-term fixed deposits profits
Less losses and fictitious
assets
 Interpretation Of Capital Gearing
Ratio
When fixed interest bearing securities and fixed
dividend bearing shares are higher than equity
shareholders funds, the company is said to be ‘highly
geared’.
Where the fixed interest hearing securities and fixed
dividend bearing shares share equal to equity share
capital it is said to be ‘evenly geared’.
When the fixed interest bearing securities and fixed
dividend bearing shares are lower than equity share
capital it is said to be ‘low geared’.
If capital gearing is high, further raising of long term
loans may be difficult and issue of equity shares may
be attractive and vice-versa
 Fixed Assets Ratio
It establishes the relationship between fixed assets and
capital employed

Fixed assets
Fixed assets ratio=
Capital employed

Ideal ratio: 0.67:1

This ratio enables to know how fixed assets are financed
i.e. by use of short term funds or by long term funds.
This ratio should not be more than 1.
 Fixed Charges cover or Debt
Service Ratio
This ratio is determined by dividing net profit by fixed
interest charges.
Net profit before deduction of interest
and income tax
Debt service ratio=
Fixed interest charges
Ideal ratio: 6 or 7 times; if the ratio is high it means
there is higher margin of safety for the long term lenders
and as such it is not difficult for the business to obtain
further long term funds and vice-versa.
This ratio indicates the financial ability of the enterprise
to meet interest payment out of current earnings
 Dividend Cover Ratio
It is the ratio between disposable profit and dividend.
Disposable profit refers to profit left over after paying
interest on long term borrowing and income tax.
Net profit after interest and tax
Dividend cover ratio=
Dividend declared
This ratio indicates the ability of the business to maintain
the dividend on shares in future. If this ratio is higher is
indicates that there is sufficient amount of retained profit.
Even if there is slight decrease in profit in the future it
will not affect payment of dividend in future
 III. Activity Ratio
Activity ratios indicate the performance of an
organisation.
This indicate the effective utilization of the
various assets of the organisation.
Most of the ratio falling under this category is
based on turnover and hence these ratios are
called as turnover ratios.
Important Ratios In Activity Ratio
Stock turnover ratio.
Debtors turnover ratio.
Creditors turnover ratio.
Wording capital turnover ratio.
Fixed assets turnover ratio.
Current assets turnover ratio.
Total assets turnover ratio.
Sales to networth ratio.
 Stock Turnover Ratio
This ratio establishes the relationship between the cost
of goods sold during a given period and the average
sock holding during that period. It tells us as to how
many times stock has turned over (sold) during the
period. Indicates operational and marketing efficiency.
Helps in evaluating inventory policy to avoid over
stocking.
Cost of goods sold
Inventory turnover ratio=
Average stock
Cost of goods sold= sales-gross profit =
opening stock + purchases – closing stock
Opening stock + Closing stock
Average stock=
2
 Interpretation Of Stock Turnover
Ratio
Ideal ratio: 8 times; A low inventory turnover may
reflect dull business, over investment in inventory,
accumulation of stock and excessive quantities of
certain inventory items in relation to immediate
requirements.
A high ratio may not be accompanied by a relatively
high net income as, profits may be sacrificed in
obtaining a large sales volume (unless accompanied
by a larger total gross profit). It may indicate under
investment in inventories. But generally, a high stock
turnover ratio means that the concern is efficient and
hence it sells its goods quickly.
 Debtor Turnover Ratio
This ratio explains the relationship of net credit sales of
a firm to its book debts indicating the rate at which cash
is generated by turnover of receivables or debtors.
The purpose of this ratio is to measure the liquidity of the
receivables or to find out the period over which
receivables remain uncollected.
Net credit sales
Debtor turnover ratio=
Average Debtors
Opening balance + closing balance
Average debtors=
2

Debtors include bills receivables along with book debts

 Average Collection Period
The average collection period represents the average
number of days for which a firm has to wait before its
receivables are converted into cash

Number of working day in year

Average collection period=
Debtor turnover ratio
 Interpretation Of Debtor Turnover
Ratio
Ideal ratio: 10 to 12 times; debt collection
period of 30 to 36 days is considered ideal.
A high debtor turnover ratio or low collection
period is indicative of sound management
policy.
The amount of trade debtors at the end of
period should not exceed a reasonable

debtors greater the expenses of collection.

 Creditors Turnover Ratio
This ratio indicates the number of times the creditors are
paid in a year. It is useful for creditors in finding out how
much time the firm is likely to take in repaying its trade
creditors.
Net credit purchases
Creditors turnover ratio=
Average creditors
Opening balance + closing balance
Average creditors=
2
Number of working days
Average payment period=
Creditors turnover ratio
 Interpretation Of Creditor Turnover
Ratio
Ideal ratio: 12 times; debt payment period of
30 days is considered ideal.
Very less creditors turnover ratio, or a high debt
payment period may indicate the firms inability
in meeting its obligation in time.
 Working Capital Turnover Ratio
This ratio indicates the number of times the working
capital is turned over in the course of the year.
Measures efficiency in working capital usage. It
establishes relationship between cost of sales and
working capital
Cost of sales
Working capital turnover ratio=
Average working capital
Opening + closing working
capital
Average working capital=
2
Interpretation of Working Capital
Turnover Ratio
A higher ratio indicates efficient utilization
of working capital and a low ratio indicates
inefficient utilization of working capital.
But a very high ratio is not a good situation
for any firm and hence care must be taken
while interpreting the ratio.
 Fixed Assets Turnover Ratio
This ratio establishes a relationship between fixed
assets and sales.

Net sales
Fixed assets turnover ratio=
Fixed assets

Ideal ratio: 5 times

A high ratio indicates better utilisation of fixed assets.
A low ratio indicates under utilisation of fixed assets.
 Total Asset Turnover Ratio
This ratio establishes a relationship between total assets
and sales. This ratio enables to know the efficient
utilisation of total assets of a business.

Net sales
Total assets turnover ratio=
Total assets

Ideal ratio: 2 times

High ratio indicates efficient utilization and ratio less than
2 indicates under utilization.
 IV. Profitability Ratio
• Profitability ratios indicate the profit earning
capacity of a business.
• Profitability ratios are calculated either in
relation to sales or in relation to investments.
• Profitability ratios can be classified into two
categories.
a) General Profitability Ratios.
b) Overall Profitability Ratios.
 General Profitability Ratios
Gross profit ratio.
Net profit ratio.
Operating ratio.
Operating profit ratio.
Expense ratio.
 Gross Profit Ratio
It expresses the relationship of gross profit to net sales
and is expressed in terms of percentage. This ratio is a
tool that indicates the degree to which selling price of
goods per unit may decline without resulting in losses.
Gross profit
Gross profit ratio= X 100
Net sales
A low gross profit ratio may indicate unfavorable
purchasing, the instability of management to develop
sales volume thereby making it impossible to buy goods
in large volume.
Higher the gross profit ratio better the results.
 Net Profit Ratio
It expresses the relationship between net profit after
taxes to sales. Measure of overall profitability useful to
proprietors, as it gibes an idea of the efficiency as well
as profitability of the business to a limited extent.

Net profit after taxes

Net profit ratio= X 100
Net sales

Higher the ratio better is the profitability

 Operating Ratio
This ratio establishes a relationship between cost of
goods sold plus other operating expenses and net sales.
This ratio is calculated mainly to ascertain the
operational efficiency of the management in their
business operations.
Cost of goods sold + operating expenses
Operating ratio=
Net sales
Higher the ratio the less favorable it is because it would
leave a smaller margin to meet interest, dividend and
other corporate needs. For a manufacturing concern it is
expected to touch a percentage of 75% to 85%. This
ratio is partial index of over all profitability.
 Operating Profit Ratio
This ratio establishes the relationship between
operation profit and net sales.
Operating profit
Operating profit ratio= X 100
Net sales

Operating profit ratio= 100-operating ratio

Operating profit= Net sales – ( cost of goods sold +

Administrative and office expenses + selling and
distributive expenses.
 Expenses Ratio
It establishes relationship between individual operation
expenses and net sales revenue.

Cost of goods sold

1. Cost of goods sold ratio=
Net sales
Office and admin exp
2. Admin. and office exp ratio=
Net sales
Selling and dist. exp
3. Selling and distribution ratio=
Net sales
Non operating expense
4. Non-operating expense ratio= X 100
Net sales
 Test Of Overall Profitability
Return on shareholders investment or Net
worth ratio.
Return on equity capital.
Return on capital employed.
Return on total resources.
Dividend yield ratio.
Preference dividend cover ratio.
Equity dividend cover ratio.
Price covering ratio.
Dividend pay out ratio.
Earning per share.
 Return On Shareholders
Investment

Shareholders investment also called return on

proprietor’s funds is the ratio of net profit to proprietor’s
funds. It is calculated by the prospective investor in the
business to find out whether the investment would be
worth-making in terms of return as compared to the risk
involved in the business.
Net profit (After tax and int)
Return on shareholders investment=
Proprietors funds
 Return On Shareholders
Investment
This ratio is of great importance to the present and
prospective shareholders as well as the management of
the company. As this ratio reveals how well the
resources of a firm are being used, higher the ratio,
better are the results. The return on shareholders
investment should be compared with the return of other
similar firms in the same industry. The inter firm
comparision of this ratio determines whether their
investments in the firm are attractive or not as the
investors would like to invest only where their return is
higher. Similarly, trend ratios can also be calculated for
a number of years to get5 an idea of the prosperity,
growth of deterioration in the company’s profitability and
efficiency.
 Return On Equity Capital
This ratio establishes the relationship between net profit
available to equity shareholders ad the amount of capital
invested by them. It is used to compare the performance
of company's equity capital with those of other
companies, and thus help the investor in choosing a
company with higher return on equity capital.

Net profit – preference dividend

Return on equity capital=
Equity share capital (paid up)
 Return On Capital Employed
This ratio is the most appropriate indicator of the earning
power of the capital employed in the business. It also
acts as a pointer to the management showing the
progress or deterioration in the earning capacity and
efficiency of the business.
Net profit before taxes and
interest on long – term loans and debentures
Return on capital employed=
Capital employed
Ideal ratio: 15%
If the actual ratio is equal ratio is equal to or above 15%
It indicates higher productivity of the capital employed
and vice versa
 Return of total resources
This ratio acts as an yardstick to assess the efficiency of
the efficiency of the operations of the business as it
indicates the extent to which assets employed in the
business are utilised to results in net profit

Net profit
Return on total recourses = X 100
Total assets
 Dividend Yield Ratio
It refers to the percentage or ratio of dividend paid per
share to the market price per share. This ratio throws
light on the effective rate of return on investment, which
potential investors may hope to earn.

Dividend paid per equity share

Dividend yield ratio =
Market price per equity share
 Preference Dividend Cover
It indicates how many times the preference dividend is
covered by profits after tax. This ratio measures the
margin o safety for preference shareholders. Such
investors normally expect their dividend to be covered
about 3 times by profits available for dividend purpose.

Profit after tax

Preference dividend cover =
Annual programme dividend
 Equity Dividend Cover
This ratio indicates the number of times the dividend is
covered by the amount of profit available for equity
shareholders.
Net profit after tax - pref dividend
Equity dividend cover =
Dividend paid on equity capital
Earning per equity share
=
Dividend per equity share
Ideal ratio: 2 times; i.e. for every Rs. 100 profits
available for dividend, Rs. 50 is retained in the business
and Rs. 50 is distributed. Higher the ratio higher is
extent of retained earnings and higher is the degree of
certainty that dividend will be repeated in future
 Price Earning Ratio
It shows how many times the annual earnings the
present shareholders are willing to pay to get a share.
This ratio helps investors to know the effect of earnings
per share on the market price of the share. This ratio
when calculated for several years can be used as term
analysis for predicting future price earning ratios and
therefore, future stock prices.

Average market price per share

Price earning ratio=
Earning per share
 Dividend Pay Out Ratio
This ratio indicates the proportion of earnings available
which equity share holders actually receive in the form of
dividend.
Dividend paid per share
Pay out ratio =
Earning per share
An investor primarily interested should invest in equity
share of a company with high pay out ratio. A company
having low pay out ratio need not necessarily be a bad
company. A company having income may like to finance
expansion out of the income, thus low pay out ratio.
investor interested in stock price appreciation may well
invest in such a company though the pay out ratio is low.
 Earning Per Share

This ratio indicates the earning per equity share. It

establishes the relationship between net profit available
for equity shareholders and the number of equity shares.

Net profit available for equity share holders

Earning per share =
Number of equity shares