WHAT IS PREFERENCE SHARE CAPITAL?

Preference capital represents a hybrid form of financing – it takes some characteristics of equity and some attributes of debentures.

It resembles equity in the following ways:

1. (i)      Preference dividend is payable only out of distributed profits
2. (ii)  Preference dividend is not an obligatory payment (the payment of preference dividend is entirely within the discretion of the directors)

Preference capital is similar to debentures in several ways:

(i)          The dividend rate of preference capital is usually fixed

(ii)        The claim of preference shareholders is prior to the claim of equity shareholders

(iii)      Preference shareholders do not normally enjoy the right to vote

ADVANTAGE AND DISADVANTAGE OF PREFERENCE CAPITAL

Preference Capital has the following Advantages:

1) There is no legal obligation to pay preference dividend. A company does not face bankruptcy or legal action if it skips preference dividend.

2) There is no redemption liability in the case of perpetual preference shares. Even in the case of redeemable preference shares, financial distress may not be much because:

(i)                 Periodic sinking fund payments are not required

(ii)               Redemption can be delayed without significant penalties

3) Preference capital is generally regarded as part of net worth. Hence, it enhances the creditworthiness of the firm.

4) Preference shares do not, under normal circumstances, carry voting right. Hence, there is no dilution of control.

Preference Capital, however suffers from some serious shortcomings:

1) Compared to debt capital, it is an expensive source of financing because the dividend paid to preference shareholders is not, unlike debt interest, a tax-deductible expense.

2) Though there is no legal obligation to pay preference dividends, skipping them can adversely affect the image of the firm in the capital market.

3) Compared to equity shareholders, preference shareholders have a prior claim on the assets and earnings of the firm.

WHAT IS OPERATING CYCLE FOR WORKING CAPITAL?

The operating cycle is the length of time between the company’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of the goods. In a manufacturing business, operating cycle is the average time that raw materials remain in stock less the period of credit taken from suppliers, plus the time taken for producing the goods, plus the time goods remain in finished inventory, plus the time taken by customers to pay for the goods.

Operating cycle concept is important for management of cash and management of working capital because the longer the operating cycle the more financial resources the company needs. Therefore, the management has to remain cautious that the operating cycle should not become too long. The stages of operating cycle could be depicted through the figure given:

The above figure would reveal that operating cycle is the time that elapses between the cash outlay and the cash realization by the sale of finished goods and realization of sundry debtors. Thus cash used in productive activity, often some times comes back from the operating cycle of the activity. The length of operating cycle of an enterprise is the sum of these four individual stages i.e. components of time.

WHAT IS WEIGHTED AVERAGE COST OF CAPITAL?

The term cost of capital means the overall composite cost of capital defined as “weighted average of the cost of each specific type of fund. The use of weighted average and not the simple average is warranted by the fact that proportions of various sources of funds in the capital structure of a firm are different.

Therefore the overall cost of capital should take into account the weighted average. The weighted cost of capital based on historical weights takes into account a long-term view.

The term cost of capital, as the acceptance criterion or investment proposals, is used in the sense of the combined cot of all sources of financing. This is mainly because focus is on the valuation of the firm as a whole. It is related to the firm’s objective of wealth maximization.

Thus, the weighted average cost of funds of a company is based on the mix of equity and loan capital and their respective costs. A distinction is usually drawn between the average cost of all funds in an existing balance sheet and the marginal cost of raising new funds.

CASH FLOW VS FUNDS FLOW

CASH FLOW - A Cash Flow Statement is a statement which shows inflows and outflows of cash and cash equivalents of an enterprise during a particular period. It provides information about cash flows, associated with the period’s operations and also about the entity’s investing and financing activities during the period.

FUND FLOW – Fund Flow Statement also referred to as the statement of “Source and Application of Funds” provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital.,

A fund flow statement is different from cash flow statement in the following ways –

• Funds flow statement is based on the concept of working capital while cash flow statement is based on cash which is only one of the element of working capital. Thus cash flow statement provides the details of funds movements.
• Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statement records inflows or outflows of cash, the difference of total inflows and outflows is the net increase or decrease in cash and cash equivalents.
• Funds Flow statement does not contain any opening and closing balance whereas in cash flow statement opening as well as closing balances of cash and cash equivalents are given.
• Funds Flow statement is more relevant in estimating the firm’s ability to meet its long-term liabilities, however, cash flow statement is more relevant in estimating the firms short-term phenomena affecting the liquidity of the business.
• The Cash Flow statement considers only the actual movement of cash whereas the funds flow statement considers the movement of funds on accrual basis.
• In cash flow statement cash from the operations are calculated after adjusting the increases and decreases in current assets and liabilities. In funds flow statement such changes in current items are adjusted in the changes of working capital.
• Cash flow statement is generally used as a tool of financial analysis which is utilized by the management for short- term financial analysis and cash planning purposes, whereas funds flow statement is useful in planning intermediate and long-term financing.

FUND FLOW STATEMENT

Fund flow statement also referred to as statement of “source and application of funds” provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital. The information required for the preparation of funds flow statement is drawn from the basic financial statements such as the Balance Sheet and Profit and loss account. “Funds Flow Statement” can be prepared on total resource basis, working capital basis and cash basis. The most commonly accepted form of fund flow is the one prepared on working capital basis.

What are the Advantages of Fund Flow Statements?

Advantages of fund flow are as follows:

• management of various companies are able to review their cash budget with the aid of fund flow statements
• Helps in the evaluation of alternative finance and investments plan
• Investors are able to measure as to how the company has utilized the funds supplied by them and its financial strengths with the aid of funds statements.
• It serves as an effective tool to the management of economic analysis
• It explains the relationship between the changes in the working capital and net profits.
• Help in the planning process of a company
• It is an effective tool in the allocation of resources
• Helps provide explicit answers to the questions regarding liquid and solvency position of the company, distribution of dividend and whether the working capital is effectively used or not.
• Helps the management of companies to forecast in advance the requirements of additional capital and plan its capital issue accordingly.
• Helps in determining how the profits of a company have been invested: whether invested in fixed assets or in inventories or ploughed back.

RATIO ANALYSIS

Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis. There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis.

Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables. This relationship can be expressed as:

1)      Fraction

2)      Percentages

3)      Proportion of numbers

These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.

ADVANTAGES OF RATIO ANALYSIS

• Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.
• Ratios avoid distortions that may result the study of absolute data or figures
• Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.
• Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.
• Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.
• Ratios are increasingly used in trend analysis.
• Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.
• Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.
• Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit standing of their borrowers and customers.

LIMITATIONS OF RATIO ANALYSIS:

An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks. Some of them are listed below:

1. Rations can sometimes be misleading if an analyst does not know the reliability and soundness of the figures from which they are computed and the financial position of the business at other times of the year. A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1

2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied.

3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year. Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations.

4. Changes in the price level make the interpretations of the ratios Invalid. The interpretation and comparison of ratios are also rendered invalid by the changing value of money. The accounting figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result. Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless.

For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased its plant and machinery at a time when prices were very low and the other purchased when prices were high, the equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally profitable. The return of the first firm is overstated because its plant and machinery have a low book value.

5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult. In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit, current assets etc. Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people.

6. Ratios are not reliable in some cases as they many be influenced by window / dressing in the balance sheet.

7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent. The balance sheet prepared at different points of time is static in nature. They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts.

8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.

While the ratios indicate what happened in the past Art outside analyst has to rely on the past ratios which may not necessarily reflect the firm’s financial position and performance in future.