Take a breath before we begin. Financial Management has a reputation among Class 12 students for being the one “scary” chapter in Business Studies, mostly because it is the only place in the whole book where numbers turn up uninvited. Here is the honest truth: the arithmetic in this chapter is gentler than anything you already do in Accountancy. What actually makes students stumble is that nobody slowed down and explained why a business borrows money in the first place.
So that is exactly what we will do together. One idea at a time. Examples from shops, homes and pocket money you already understand. Formulas only after the idea makes sense. By the end of this page you should be able to read a board question that says “Advise the company” and know immediately which factors the examiner is fishing for.
Read this the way you would listen to a friend explaining something — slowly, and re-reading bits if you need to. Just please do not skip the worked examples. That is where the marks are hiding.
What You’ll Learn
Everything below is inside the official CBSE 2026-27 syllabus for Unit 9. Nothing extra has been added to frighten you, and nothing has been quietly dropped. Tap any line to jump straight to it.
- What Financial Management Actually Means
- The Role And Objectives Of Financial Management
- The Three Financial Decisions At A Glance
- The Investment Decision (Capital Budgeting)
- The Financing Decision
- The Dividend Decision
- Financial Planning: Concept And Importance
- Capital Structure: Concept And Meaning
- Financial Leverage And Trading On Equity
- Factors Affecting Capital Structure
- Fixed Capital And What Decides Its Size
- Working Capital And What Decides Its Size
- Quick Revision And Exam Strategy
🎯 Try This
Take one real purchase your family is planning, such as a phone, a scooter or a fridge, and write two financing plans on paper: one paying fully from savings and one on EMI. Work out the total cost of each and decide which you would recommend and why. (25-30 min)
Your Game Plan
If you are starting this chapter today, work in this order. It is deliberately arranged so each idea leans on the one before it.
- Day 1 — get the map. Read the first three sections only. Learn the three financial decisions by heart. Everything else in this chapter is a branch off one of those three.
- Day 2 — the three decisions in detail. Investment, financing, dividend. For each one learn the meaning first and only then the factors. Say the factors aloud; they stick better than silent reading.
- Day 3 — financial planning and capital structure. Take trading on equity slowly and actually work the numbers with a pen. Do not just read my solved examples — cover the answer and redo them.
- Day 4 — fixed and working capital. These two carry a huge number of 3-mark and 4-mark questions. Learn the factor lists properly.
- Day 5 — the worksheet. Attempt every question with the answer hidden. Only then reveal.
- Every day after — five minutes. Recite the three decisions, the capital-structure factors and the working-capital factors. Five minutes daily beats three hours the night before.
Study Notes
What Financial Management Actually Means
Imagine your family runs a small stationery shop. Every single month somebody in that family has to answer three uncomfortable questions. How much money do we need? Where will we get it from? And once we have it, where do we put it — new shelves, more stock, or the bank? Answering those questions carefully, month after month, is financial management. It is not accounting. Accounting records what already happened; financial management decides what should happen next.
Formally: financial management is the planning, arranging, controlling and monitoring of the money a business uses, so that the money the owners have put in keeps growing in value. Notice the last part carefully, because that is the bit students forget. The goal is not simply to have lots of cash lying around. The goal is that the wealth of the shareholders goes up.
Why it works this way. Money inside a business is never free. If it came from the owners, they gave up other opportunities to hand it over. If it came from a bank, interest is ticking. So every rupee sitting idle is a rupee quietly costing you something. Financial management exists to make sure no rupee is idle and no rupee is reckless. That single sentence explains almost every rule in this chapter.
Key Idea — the one-line definition to memorise Financial management is concerned with the procurement (getting) and utilisation (using) of funds in a way that maximises the wealth of the owners. If you can write that sentence you have secured the definition mark in any question on this chapter.
Example 1 — your pocket money is a tiny finance department
Suppose you get ₹2,000 a month. You decide ₹600 goes to the canteen, ₹900 to a coaching book fund, and ₹500 stays untouched for emergencies. You have just made all three financial decisions without knowing it. Deciding to build the book fund is an investment decision (locking money into something that will pay off later). Deciding to borrow ₹300 from your sister until the first of the month is a financing decision. Deciding how much you actually get to spend on yourself versus save is the household version of a dividend decision. A company does the same thing, only with more zeroes and a board meeting.
Do not move on until that feels comfortable. Really. If the pocket-money picture is clear in your head, the rest of this chapter is just the same three questions dressed in formal language.
The Role And Objectives Of Financial Management
Students often write “the role of financial management is to manage finance” and lose the mark. Fair enough — it is a circular sentence. So let us make the role concrete. Financial management is not one activity sitting in a corner; its decisions leak into every part of the balance sheet. That is genuinely the point the examiner wants.
Where financial management shows up
- The size and composition of fixed assets. A decision to buy a ₹40 lakh machine instantly changes how much of the business is locked in fixed assets.
- The quantum of current assets. How much stock to keep, how much credit to give customers, how much cash to hold — all financial calls.
- The amount of long-term and short-term finance used. More borrowing means a heavier interest burden every year.
- The break-up of long-term finance into debt and equity. This is the capital structure decision we will study in detail.
- All items in the profit and loss account. Interest, depreciation and even tax all move because of financial decisions.
The objective: wealth maximisation, not profit maximisation
The primary aim of financial management is maximisation of shareholders’ wealth — which in practice means maximising the market price of an equity share. Every financial decision should be tested against one question: does this push the share price up or down?
Why not simply “maximise profit”? Because profit is a short-sighted and easily distorted target. A firm can raise this year’s profit by refusing to service its machines, sacking trained staff or slashing quality — and destroy itself in three years. Profit also ignores two things wealth does not: timing (a rupee earned today is worth more than a rupee earned in five years) and risk (a risky rupee is worth less than a safe rupee). Share price quietly bakes both of those in, which is why it is the better yardstick.
Example 2 — the tempting shortcut that costs you everything
Two sweet shops in the same market both earn a profit of ₹5,00,000 this year. Shop A got there by using cheaper oil and skipping the annual servicing of its refrigeration unit. Shop B got there normally and also spent ₹80,000 on a new display counter, so its profit could have been ₹5,80,000.
On a pure “maximise profit” test, Shop A wins. On a wealth test, Shop B wins easily — because next year Shop A faces a compressor breakdown, a reputation for stale sweets, and falling footfall, while Shop B has a stronger, safer earning stream. If both were listed companies, an informed buyer would pay more for Shop B’s shares. That is precisely why the syllabus says wealth maximisation, not profit maximisation.
On a pure “maximise profit” test, Shop A wins. On a wealth test, Shop B wins easily — because next year Shop A faces a compressor breakdown, a reputation for stale sweets, and falling footfall, while Shop B has a stronger, safer earning stream. If both were listed companies, an informed buyer would pay more for Shop B’s shares. That is precisely why the syllabus says wealth maximisation, not profit maximisation.
Exam Tip — the two words that earn the mark Whenever you argue for wealth over profit, the examiner is looking for the words timing and risk. Write: “Profit maximisation ignores the timing of returns and the risk attached to them, whereas wealth maximisation accounts for both.” Short, complete, full marks.
The Three Financial Decisions At A Glance
Colour code used all through this page: blue = investment decision, yellow = financing decision, green = dividend decision.
Every question in this chapter, without exception, hangs off one of those three branches. When a question confuses you, your first move should be to ask: which of the three is this really about? Half the time that alone tells you the answer.
| Basis | Investment Decision | Financing Decision | Dividend Decision |
|---|---|---|---|
| Question asked | Where should the funds be applied? | From which sources should funds be raised? | How much profit should reach the shareholders? |
| Also called | Capital budgeting (for long-term) | Capital structure decision | Profit distribution decision |
| Affects mainly | Asset side of the balance sheet | Liabilities and equity side | Reserves and surplus |
| Key risk if wrong | Money locked in an unprofitable asset, very hard to reverse | Fixed interest burden the firm cannot carry | Unhappy shareholders or starved growth plans |
| Everyday parallel | Should we buy a new fridge for the shop? | Savings, or a loan from the bank? | How much of this year’s earnings do we take home? |
Example 3 — one bakery, three decisions in a single afternoon
The owners of a neighbourhood bakery meet on a Sunday. Three things get decided.
(a) They will install a second oven costing ₹6,00,000 because weekend orders are being turned away. → Investment decision, and specifically a capital budgeting decision, because the money is locked up for years.
(b) Of that ₹6,00,000 they will put in ₹4,00,000 from retained profits and take a ₹2,00,000 bank loan. → Financing decision, and it changes their capital structure.
(c) Of this year’s profit of ₹9,00,000, the partners will draw ₹3,00,000 and leave ₹6,00,000 in the business. → Dividend decision in company language.
Notice that (c) fed straight into (b): because they kept ₹6,00,000 back, they only had to borrow ₹2,00,000. The three decisions are never independent, and saying so in a long answer earns you a mark.
(a) They will install a second oven costing ₹6,00,000 because weekend orders are being turned away. → Investment decision, and specifically a capital budgeting decision, because the money is locked up for years.
(b) Of that ₹6,00,000 they will put in ₹4,00,000 from retained profits and take a ₹2,00,000 bank loan. → Financing decision, and it changes their capital structure.
(c) Of this year’s profit of ₹9,00,000, the partners will draw ₹3,00,000 and leave ₹6,00,000 in the business. → Dividend decision in company language.
Notice that (c) fed straight into (b): because they kept ₹6,00,000 back, they only had to borrow ₹2,00,000. The three decisions are never independent, and saying so in a long answer earns you a mark.
Common Mistake — mixing up “investment” with “investing in shares” In this chapter, investment decision does not mean buying shares of other companies. It means deciding where the firm’s own funds get deployed — into machines, buildings, stock, or debtors. Students lose easy marks by writing about the stock market here.
The Investment Decision (Capital Budgeting)
Meaning. The investment decision is about where the firm’s funds will be deployed. It splits neatly into two types, and the split matters because examiners ask about them separately.
- Long-term investment decision (capital budgeting). Money committed to assets that will serve the business for many years — a new plant, a delivery van, a modernisation programme, launching a new product line. These involve large sums and are extremely difficult to reverse.
- Short-term investment decision (working capital decision). Money committed to current assets — how much stock to hold, how much credit to extend, how much cash to keep in hand. These affect the firm’s day-to-day liquidity.
Capital budgeting deserves respect for one blunt reason: the decision is largely irreversible. If your family buys a ₹6 lakh oven and it turns out nobody wants your bread, you cannot un-buy it. You sell it second-hand at a painful loss. Meanwhile the wrong decision has also blocked money you could have used elsewhere. This is why capital budgeting decisions are studied and re-studied before approval.
Factors affecting the investment decision
- Cash flows of the project. A project brings money in and takes money out over its life. The pattern and size of those net cash flows is the single biggest input.
- The rate of return. Between two projects of similar risk, the one earning a higher return wins. If Project A promises 15% and Project B of the same risk promises 11%, A is chosen.
- The investment criteria involved. Firms use techniques such as payback period, rate of return and other capital-budgeting methods; the technique chosen and the cut-off applied will decide which proposals clear the bar.
Exam Tip — only three factors here The investment decision has a short factor list: cash flows, rate of return, investment criteria. Students often pad it with factors borrowed from capital structure and lose time. Keep this list tight and use the saved minutes on the longer lists later in the chapter.
Example 4 — two proposals, one budget (a gentle numerical)
A firm has ₹10,00,000 to invest and two proposals on the table.
Proposal X: costs ₹10,00,000, brings in ₹2,50,000 every year for 6 years.
Proposal Y: costs ₹10,00,000, brings in ₹4,00,000 every year for 3 years.
Step 1 — total cash brought in.
X: ₹2,50,000 × 6 = ₹15,00,000, so net gain = ₹15,00,000 − ₹10,00,000 = ₹5,00,000
Y: ₹4,00,000 × 3 = ₹12,00,000, so net gain = ₹12,00,000 − ₹10,00,000 = ₹2,00,000
Step 2 — payback period (how long before the cost comes back):
X: ₹10,00,000 ÷ ₹2,50,000 = 4 years
Y: ₹10,00,000 ÷ ₹4,00,000 = 2.5 years
Reading the answer. X earns more in total, but Y returns your money one and a half years sooner. A firm short of cash, or in a fast-changing industry where a 6-year forecast is guesswork, will sensibly pick Y despite the smaller total. That tension — more money later versus safer money sooner — is the heart of every capital budgeting decision, and it is exactly the “timing and risk” idea from the previous section.
Proposal X: costs ₹10,00,000, brings in ₹2,50,000 every year for 6 years.
Proposal Y: costs ₹10,00,000, brings in ₹4,00,000 every year for 3 years.
Step 1 — total cash brought in.
X: ₹2,50,000 × 6 = ₹15,00,000, so net gain = ₹15,00,000 − ₹10,00,000 = ₹5,00,000
Y: ₹4,00,000 × 3 = ₹12,00,000, so net gain = ₹12,00,000 − ₹10,00,000 = ₹2,00,000
Step 2 — payback period (how long before the cost comes back):
X: ₹10,00,000 ÷ ₹2,50,000 = 4 years
Y: ₹10,00,000 ÷ ₹4,00,000 = 2.5 years
Reading the answer. X earns more in total, but Y returns your money one and a half years sooner. A firm short of cash, or in a fast-changing industry where a 6-year forecast is guesswork, will sensibly pick Y despite the smaller total. That tension — more money later versus safer money sooner — is the heart of every capital budgeting decision, and it is exactly the “timing and risk” idea from the previous section.
Before you attempt the worksheet, it helps to have Planning fresh in your mind — several practice questions borrow from it.
The Financing Decision
Meaning. The financing decision answers: from which sources, and in what proportion, will we raise the money? Broadly the firm chooses between owners’ funds (equity share capital and retained earnings) and borrowed funds (debentures, loans, public deposits).
The difference between the two is not just paperwork. Borrowed funds carry a legal obligation: interest must be paid whether or not the firm made a profit, and the principal must be returned on a fixed date. Owners’ funds carry no such promise — if there is no profit, there is no dividend, and nobody sues you. So debt is cheaper but riskier; equity is dearer but safer. Hold on to that sentence; the whole capital-structure discussion later is built on it.
Why is debt cheaper? Two reasons. First, lenders take less risk than owners (they get paid first, often against security), so they accept a lower rate. Second — and this is the part students miss — interest is a deductible expense for tax, while dividend is not. So the government effectively pays part of your interest bill.
Factors affecting the financing decision
- Cost. Raising funds from different sources costs different amounts. The firm leans towards the cheaper source, other things being equal.
- Risk. Borrowed funds carry more risk than owners’ funds, because interest and repayment are compulsory.
- Floatation cost. The cost of issuing securities — brokerage, underwriting, advertising, prospectus. A higher floatation cost makes a source less attractive.
- Cash flow position of the business. Strong, steady cash inflows make it comfortable to service debt. Weak or erratic cash flows argue for equity.
- Level of fixed operating costs. If the firm already carries heavy fixed costs such as rent, insurance and building maintenance, it should keep fixed financial costs (interest) low. Piling one fixed burden on another is how firms break.
- Control considerations. Issuing fresh equity brings in new owners and dilutes existing control. Borrowing does not. Promoters who want to keep control tilt towards debt.
- State of the capital market. When markets are booming, equity issues are easy to sell; during a downturn firms lean on debt instead.
Example 5 — how much is “too much” debt? (with numbers)
A company has long-term funds of ₹80,00,000, made up of ₹50,00,000 equity and ₹30,00,000 of 10% debentures. Its EBIT for the year is ₹9,00,000. Tax rate is 30%.
Step 1 — debt-equity ratio.
₹30,00,000 ÷ ₹50,00,000 = 0.6 : 1. So debt is 30 ÷ 80 = 37.5% of long-term funds.
Step 2 — the annual interest bill.
10% of ₹30,00,000 = ₹3,00,000. Wait — read the question again. Here the actual interest charged in the accounts is ₹1,50,000 because the debentures were issued exactly halfway through the year. Use the figure given, not the one you assume.
Step 3 — interest coverage ratio.
EBIT ÷ Interest = ₹9,00,000 ÷ ₹1,50,000 = 6 times. The firm earns six rupees of operating profit for every rupee of interest it owes. That is a comfortable cushion — profits could fall by more than 80% before interest became unpayable.
Step 4 — the real cost of that debt.
Stated rate 10%, but interest is tax deductible, so effective cost = 10% × (1 − 0.30) = 7%. Equity gets no such discount, because dividend is paid out of taxed profit.
Conclusion: with coverage of 6 times and an after-tax debt cost of only 7%, this company has room to borrow a little more — provided its cash flows stay steady.
Step 1 — debt-equity ratio.
₹30,00,000 ÷ ₹50,00,000 = 0.6 : 1. So debt is 30 ÷ 80 = 37.5% of long-term funds.
Step 2 — the annual interest bill.
10% of ₹30,00,000 = ₹3,00,000. Wait — read the question again. Here the actual interest charged in the accounts is ₹1,50,000 because the debentures were issued exactly halfway through the year. Use the figure given, not the one you assume.
Step 3 — interest coverage ratio.
EBIT ÷ Interest = ₹9,00,000 ÷ ₹1,50,000 = 6 times. The firm earns six rupees of operating profit for every rupee of interest it owes. That is a comfortable cushion — profits could fall by more than 80% before interest became unpayable.
Step 4 — the real cost of that debt.
Stated rate 10%, but interest is tax deductible, so effective cost = 10% × (1 − 0.30) = 7%. Equity gets no such discount, because dividend is paid out of taxed profit.
Conclusion: with coverage of 6 times and an after-tax debt cost of only 7%, this company has room to borrow a little more — provided its cash flows stay steady.
Common Mistake — confusing fixed operating cost with fixed financial cost Rent, insurance and salaries are fixed operating costs. Interest on debentures and loans is a fixed financial cost. The rule is that a firm already loaded with the first kind should go easy on the second kind. Write both terms correctly and the mark is yours.
The Dividend Decision
Meaning. Once a company has earned a profit after tax, somebody must decide how much of it goes out to shareholders as dividend and how much stays inside the business as retained earnings. That is the dividend decision. Its defining feature is that the two parts must add up to the whole — every rupee paid out is a rupee not available for growth, and every rupee kept back is a rupee the shareholder did not receive this year.
The guiding principle is the same as everywhere else: choose the split that maximises shareholders’ wealth. Sometimes that means paying generously, because shareholders value certain cash today. Sometimes it means paying little, because the company has a project earning far more than shareholders could earn on their own.
Factors affecting the dividend decision
- Amount of earnings. Dividend is paid out of current and past profits, so higher earnings allow a higher dividend.
- Stability of earnings. A company with steady profits can afford a higher and more predictable dividend than one whose profits swing wildly.
- Stability of dividends. Companies usually try to keep the dividend per share steady, changing it only when they are confident the new level can be sustained. A cut sends a bad signal to the market.
- Growth opportunities. A company with attractive expansion plans retains more and pays less, because the money earns more inside the firm.
- Cash flow position. Dividend is paid in cash. Profit on paper is not the same as cash in the bank — a profitable firm with all its money tied up in stock and debtors may simply be unable to pay.
- Shareholders’ preference. If the shareholder base includes many retired investors who depend on the income, management leans towards a regular, generous dividend.
- Taxation policy. The tax treatment of dividends in the hands of shareholders influences how attractive a cash payout is compared with retention.
- Stock market reaction. A rise in dividend is generally read as good news and lifts the share price; a cut usually pushes it down.
- Access to capital market. Large, well-known companies can raise fresh funds easily, so they are less dependent on retained profits and can pay more.
- Legal constraints. Provisions of the Companies Act place restrictions on dividend declaration, and these must be respected.
- Contractual constraints. Lenders often insert clauses in loan agreements limiting dividend payments until the loan is repaid.
Example 6 — splitting the profit, rupee by rupee
A company earns a profit after tax of ₹12,00,000. It has 4,00,000 equity shares of ₹10 each. The board decides on a payout ratio of 40%.
Step 1 — earnings per share.
EPS = ₹12,00,000 ÷ 4,00,000 shares = ₹3.00 per share
Step 2 — total dividend.
40% of ₹12,00,000 = ₹4,80,000
Step 3 — dividend per share.
₹4,80,000 ÷ 4,00,000 shares = ₹1.20 per share
(Check the other way: 40% of ₹3.00 = ₹1.20. Same answer, so the arithmetic is sound.)
Step 4 — retained earnings.
₹12,00,000 − ₹4,80,000 = ₹7,20,000 stays in the business
Step 5 — the rate of dividend.
Companies announce dividend as a percentage of face value, not of EPS. ₹1.20 on a ₹10 share = 12% dividend.
What this means. That ₹7,20,000 retained is free finance — no interest, no floatation cost, no dilution of control. It is exactly why a fast-growing company keeps its payout ratio low, and why a mature company with nowhere exciting to spend money pays out much more.
Step 1 — earnings per share.
EPS = ₹12,00,000 ÷ 4,00,000 shares = ₹3.00 per share
Step 2 — total dividend.
40% of ₹12,00,000 = ₹4,80,000
Step 3 — dividend per share.
₹4,80,000 ÷ 4,00,000 shares = ₹1.20 per share
(Check the other way: 40% of ₹3.00 = ₹1.20. Same answer, so the arithmetic is sound.)
Step 4 — retained earnings.
₹12,00,000 − ₹4,80,000 = ₹7,20,000 stays in the business
Step 5 — the rate of dividend.
Companies announce dividend as a percentage of face value, not of EPS. ₹1.20 on a ₹10 share = 12% dividend.
What this means. That ₹7,20,000 retained is free finance — no interest, no floatation cost, no dilution of control. It is exactly why a fast-growing company keeps its payout ratio low, and why a mature company with nowhere exciting to spend money pays out much more.
Common Mistake — announcing a “30% dividend” on the wrong base Dividend rate is always a percentage of the face value of the share, never of the market price and never of EPS. A 12% dividend on a ₹10 share is ₹1.20, even if that share trades at ₹250 in the market. Get this wrong in a numerical and the whole answer collapses.
Financial Planning: Concept And Importance
Concept. Financial planning is the process of estimating the funds a business will need and deciding where those funds will come from. In one line: it is deciding in advance how much money is required, when it will be required, and how it will be arranged.
The output of financial planning is a financial plan, usually expressed through budgets. Its twin objectives are worth memorising word for word, because they are frequently asked:
- To ensure availability of funds whenever they are required. This includes estimating the amount needed, the timing, and the sources.
- To see that the firm does not raise resources unnecessarily. Excess funding is almost as harmful as a shortage, because idle money still carries a cost.
Why the second objective surprises students. Most people assume more money is always better. It is not. Imagine your parents borrow ₹5,00,000 for a shop renovation that only needed ₹3,00,000. The extra ₹2,00,000 sits in the account doing nothing while interest accumulates on the whole amount. Shortage of funds hurts operations; surplus of funds hurts profitability. Good financial planning threads the needle between the two.
Importance of financial planning
- It helps in forecasting what may happen in future. Different scenarios are thought through in advance, so shocks are less shocking.
- It helps in avoiding business shocks and surprises and prepares the firm to face them.
- It helps in coordinating various business functions such as production and sales, by linking them through a common financial plan.
- It reduces waste, duplication of effort and gaps in planning by making the plan detailed and specific.
- It links the present with the future, tying today’s decisions to tomorrow’s requirements.
- It provides a link between investment and financing decisions, on a continuous basis.
- It makes evaluation easier. A detailed plan becomes the benchmark against which actual performance is judged, which makes control possible.
Key Idea — planning is not the same as arranging Financial planning happens before the money is raised. It is a thinking exercise, not a fund-raising exercise. The financing decision is what actually goes out and gets the money. Keep the two separate in your answers and your explanations will read far more confidently.
Example 7 — a model board answer (4 marks)
Question: “Sunrise Garments is a three-year-old firm that has twice run out of cash in the middle of the festive season and once borrowed far more than it needed. Identify the function of financial management being neglected and explain any three points of its importance.”
Model answer.
Identification (1 mark): The function being neglected is financial planning — the process of estimating the funds required by the business and determining the sources from which they will be raised.
Importance, any three (3 marks):
(i) It helps in forecasting what may happen in future. Had Sunrise forecast its festive-season sales and the stock build-up needed for it, the cash shortage could have been anticipated months in advance.
(ii) It helps in avoiding business shocks and surprises. Running dry mid-season is precisely the kind of shock a plan is meant to remove.
(iii) It ensures the firm does not raise resources unnecessarily. Over-borrowing once means the firm paid interest on money it never used, reducing its profitability.
Why this scores full marks: it names the concept, defines it, gives three separate points, and — crucially — ties each point back to the facts in the case. Never list textbook points without touching the case. That link is what separates a 3 from a 4.
Model answer.
Identification (1 mark): The function being neglected is financial planning — the process of estimating the funds required by the business and determining the sources from which they will be raised.
Importance, any three (3 marks):
(i) It helps in forecasting what may happen in future. Had Sunrise forecast its festive-season sales and the stock build-up needed for it, the cash shortage could have been anticipated months in advance.
(ii) It helps in avoiding business shocks and surprises. Running dry mid-season is precisely the kind of shock a plan is meant to remove.
(iii) It ensures the firm does not raise resources unnecessarily. Over-borrowing once means the firm paid interest on money it never used, reducing its profitability.
Why this scores full marks: it names the concept, defines it, gives three separate points, and — crucially — ties each point back to the facts in the case. Never list textbook points without touching the case. That link is what separates a 3 from a 4.
Capital Structure: Concept And Meaning
Concept. Capital structure is the mix of long-term sources of funds a company uses — essentially the proportion of borrowed funds to owners’ funds. It is usually written as a debt-equity ratio:
Debt–Equity Ratio = Debt ÷ Equity
Here Debt means long-term borrowed funds — debentures, long-term loans, public deposits. Equity means owners’ funds — equity share capital, preference share capital and reserves and surplus. Note that retained profits sitting in reserves count as owners’ funds, because they belong to shareholders even though they were never handed over.
| Basis | Equity (Owners’ Funds) | Debt (Borrowed Funds) |
|---|---|---|
| Return promised | Dividend — paid only if profits allow, no legal compulsion | Interest — must be paid whether or not there is profit |
| Repayment of principal | Not repaid during the life of the company | Repayable on a fixed maturity date |
| Tax treatment | Dividend is not a deductible expense | Interest is deductible, lowering the effective cost |
| Cost to the company | Higher — investors demand more for taking more risk | Lower — less risk to the lender, plus the tax shield |
| Effect on control | Fresh equity dilutes the control of existing owners | Lenders get no voting rights, so control is untouched |
| Risk added to the firm | None — it is permanent, obligation-free capital | Financial risk — the danger of being unable to meet fixed payments |
An optimal capital structure is the debt-equity mix at which the cost of capital is lowest and the market value of the share is highest. It is a balancing act between the cheapness of debt and the safety of equity.
Example 8 — EPS when preference shares are in the mix
A company reports EBIT of ₹8,00,000. It pays interest of ₹1,00,000 on its debentures. The tax rate is 30%. It must also pay a preference dividend of ₹50,000. There are 1,00,000 equity shares outstanding.
Step 1 — earnings before tax.
₹8,00,000 − ₹1,00,000 = ₹7,00,000
Step 2 — tax at 30%.
30% of ₹7,00,000 = ₹2,10,000
Step 3 — earnings after tax.
₹7,00,000 − ₹2,10,000 = ₹4,90,000
Step 4 — subtract preference dividend.
₹4,90,000 − ₹50,000 = ₹4,40,000 available to equity shareholders
Step 5 — EPS.
₹4,40,000 ÷ 1,00,000 = ₹4.40 per share
The one thing to notice. Interest was deducted before tax; preference dividend was deducted after tax. That single difference is why debt carries a tax advantage and preference capital does not. Students lose marks every year by subtracting preference dividend in the wrong place.
Step 1 — earnings before tax.
₹8,00,000 − ₹1,00,000 = ₹7,00,000
Step 2 — tax at 30%.
30% of ₹7,00,000 = ₹2,10,000
Step 3 — earnings after tax.
₹7,00,000 − ₹2,10,000 = ₹4,90,000
Step 4 — subtract preference dividend.
₹4,90,000 − ₹50,000 = ₹4,40,000 available to equity shareholders
Step 5 — EPS.
₹4,40,000 ÷ 1,00,000 = ₹4.40 per share
The one thing to notice. Interest was deducted before tax; preference dividend was deducted after tax. That single difference is why debt carries a tax advantage and preference capital does not. Students lose marks every year by subtracting preference dividend in the wrong place.
Financial Leverage And Trading On Equity
The same company, the same ₹40,00,000, the same two plans — only the rate of return changes. Orange = all-equity plan, yellow = the plan using debt. Bar heights are drawn exactly to the EPS figures calculated in Examples 9 and 10.
This is the section that makes Financial Management feel like a numerical chapter, so let us go very slowly. Financial leverage is simply the proportion of debt in a company’s total capital. When a company deliberately uses debt in order to push up the earnings of its equity shareholders, we say it is trading on equity.
The idea in plain language. Suppose you can borrow money at 10% and put it to work in a business that earns 15%. You keep the 5% difference without putting in a single rupee more of your own. That is trading on equity. It sounds like free money, and in good years it very nearly is. But turn the situation around — borrow at 10% and earn only 8% — and you are now paying 2% out of your own pocket, every year, on money that is not even yours.
Key Rule — the one comparison that decides everything Trading on equity increases EPS only when the rate of return on investment (ROI) is higher than the rate of interest on debt. If ROI is lower than the interest rate, adding debt reduces EPS. If they are equal, EPS does not change. Every single trading-on-equity question in your board paper is testing this one comparison — so before you compute anything, look at ROI and look at the interest rate.
Example 9 — trading on equity when it works (ROI 15%, interest 10%)
A company needs ₹40,00,000. It expects a return on investment of 15%. Debt is available at 10%. Tax rate is 30%. Equity shares have a face value of ₹10. Two plans are considered:
Plan A — the whole ₹40,00,000 from equity.
Plan B — ₹20,00,000 equity and ₹20,00,000 of 10% debt.
Step 1 — EBIT is the same under both plans. EBIT depends on how the money is used, not how it was raised.
EBIT = 15% of ₹40,00,000 = ₹6,00,000
Step 2 — Plan A (all equity).
Number of shares = ₹40,00,000 ÷ ₹10 = 4,00,000 shares
Interest = Nil, so EBT = ₹6,00,000
Tax at 30% = ₹1,80,000
Profit after tax = ₹6,00,000 − ₹1,80,000 = ₹4,20,000
EPS = ₹4,20,000 ÷ 4,00,000 = ₹1.05
Step 3 — Plan B (half debt).
Number of shares = ₹20,00,000 ÷ ₹10 = 2,00,000 shares
Interest = 10% of ₹20,00,000 = ₹2,00,000
EBT = ₹6,00,000 − ₹2,00,000 = ₹4,00,000
Tax at 30% = ₹1,20,000
Profit after tax = ₹4,00,000 − ₹1,20,000 = ₹2,80,000
EPS = ₹2,80,000 ÷ 2,00,000 = ₹1.40
Step 4 — compare. EPS rises from ₹1.05 to ₹1.40, a gain of ₹0.35 per share.
Why it worked. Look carefully: profit after tax actually fell, from ₹4,20,000 to ₹2,80,000. So how did EPS rise? Because the number of shares fell much more sharply — halved, from 4,00,000 to 2,00,000. The smaller cake is being cut into far fewer slices, so each slice is bigger. That is the whole mechanism of trading on equity, and being able to explain it in exactly those words is worth a mark.
Plan A — the whole ₹40,00,000 from equity.
Plan B — ₹20,00,000 equity and ₹20,00,000 of 10% debt.
Step 1 — EBIT is the same under both plans. EBIT depends on how the money is used, not how it was raised.
EBIT = 15% of ₹40,00,000 = ₹6,00,000
Step 2 — Plan A (all equity).
Number of shares = ₹40,00,000 ÷ ₹10 = 4,00,000 shares
Interest = Nil, so EBT = ₹6,00,000
Tax at 30% = ₹1,80,000
Profit after tax = ₹6,00,000 − ₹1,80,000 = ₹4,20,000
EPS = ₹4,20,000 ÷ 4,00,000 = ₹1.05
Step 3 — Plan B (half debt).
Number of shares = ₹20,00,000 ÷ ₹10 = 2,00,000 shares
Interest = 10% of ₹20,00,000 = ₹2,00,000
EBT = ₹6,00,000 − ₹2,00,000 = ₹4,00,000
Tax at 30% = ₹1,20,000
Profit after tax = ₹4,00,000 − ₹1,20,000 = ₹2,80,000
EPS = ₹2,80,000 ÷ 2,00,000 = ₹1.40
Step 4 — compare. EPS rises from ₹1.05 to ₹1.40, a gain of ₹0.35 per share.
Why it worked. Look carefully: profit after tax actually fell, from ₹4,20,000 to ₹2,80,000. So how did EPS rise? Because the number of shares fell much more sharply — halved, from 4,00,000 to 2,00,000. The smaller cake is being cut into far fewer slices, so each slice is bigger. That is the whole mechanism of trading on equity, and being able to explain it in exactly those words is worth a mark.
Example 10 — the same company in a bad year (ROI 8%, interest 10%)
Everything is identical to Example 9, except that the expected return on investment is only 8%.
Step 1 — EBIT. 8% of ₹40,00,000 = ₹3,20,000
Step 2 — Plan A (all equity, 4,00,000 shares).
EBT = ₹3,20,000; Tax at 30% = ₹96,000
Profit after tax = ₹3,20,000 − ₹96,000 = ₹2,24,000
EPS = ₹2,24,000 ÷ 4,00,000 = ₹0.56
Step 3 — Plan B (2,00,000 shares, interest ₹2,00,000).
EBT = ₹3,20,000 − ₹2,00,000 = ₹1,20,000
Tax at 30% = ₹36,000
Profit after tax = ₹1,20,000 − ₹36,000 = ₹84,000
EPS = ₹84,000 ÷ 2,00,000 = ₹0.42
Step 4 — compare. EPS falls from ₹0.56 to ₹0.42, a loss of ₹0.14 per share.
Why it failed. The borrowed ₹20,00,000 earned 8% (₹1,60,000) but cost 10% (₹2,00,000). The ₹40,000 gap had to be paid out of the equity shareholders’ share of the profits. Debt is a lever, and a lever pushes both ways.
Step 1 — EBIT. 8% of ₹40,00,000 = ₹3,20,000
Step 2 — Plan A (all equity, 4,00,000 shares).
EBT = ₹3,20,000; Tax at 30% = ₹96,000
Profit after tax = ₹3,20,000 − ₹96,000 = ₹2,24,000
EPS = ₹2,24,000 ÷ 4,00,000 = ₹0.56
Step 3 — Plan B (2,00,000 shares, interest ₹2,00,000).
EBT = ₹3,20,000 − ₹2,00,000 = ₹1,20,000
Tax at 30% = ₹36,000
Profit after tax = ₹1,20,000 − ₹36,000 = ₹84,000
EPS = ₹84,000 ÷ 2,00,000 = ₹0.42
Step 4 — compare. EPS falls from ₹0.56 to ₹0.42, a loss of ₹0.14 per share.
Why it failed. The borrowed ₹20,00,000 earned 8% (₹1,60,000) but cost 10% (₹2,00,000). The ₹40,000 gap had to be paid out of the equity shareholders’ share of the profits. Debt is a lever, and a lever pushes both ways.
Example 11 — the break-even case, where debt makes no difference
A firm needs ₹20,00,000. ROI is 12%. Debt is available at exactly 12%. Tax is 30%. Shares are ₹10 each.
EBIT = 12% of ₹20,00,000 = ₹2,40,000
Plan A — all equity (2,00,000 shares):
EBT = ₹2,40,000; PAT = ₹2,40,000 × 70% = ₹1,68,000
EPS = ₹1,68,000 ÷ 2,00,000 = ₹0.84
Plan B — ₹10,00,000 equity (1,00,000 shares) + ₹10,00,000 debt at 12%:
Interest = ₹1,20,000; EBT = ₹2,40,000 − ₹1,20,000 = ₹1,20,000
PAT = ₹1,20,000 × 70% = ₹84,000
EPS = ₹84,000 ÷ 1,00,000 = ₹0.84
Identical. When ROI equals the interest rate, the borrowed money earns exactly what it costs, so there is nothing left over for equity shareholders and nothing taken away either. This is the tipping point. Above it, leverage helps; below it, leverage hurts. If you understand this example, you understand the whole section.
EBIT = 12% of ₹20,00,000 = ₹2,40,000
Plan A — all equity (2,00,000 shares):
EBT = ₹2,40,000; PAT = ₹2,40,000 × 70% = ₹1,68,000
EPS = ₹1,68,000 ÷ 2,00,000 = ₹0.84
Plan B — ₹10,00,000 equity (1,00,000 shares) + ₹10,00,000 debt at 12%:
Interest = ₹1,20,000; EBT = ₹2,40,000 − ₹1,20,000 = ₹1,20,000
PAT = ₹1,20,000 × 70% = ₹84,000
EPS = ₹84,000 ÷ 1,00,000 = ₹0.84
Identical. When ROI equals the interest rate, the borrowed money earns exactly what it costs, so there is nothing left over for equity shareholders and nothing taken away either. This is the tipping point. Above it, leverage helps; below it, leverage hurts. If you understand this example, you understand the whole section.
Common Mistake — changing EBIT between the two plans EBIT is earnings before interest and tax. It is produced by the assets, so it stays the same no matter how the funds were raised. A shocking number of students recalculate EBIT for the debt plan by subtracting interest first. Do not. Start both plans from the same EBIT figure, then subtract interest only in the plan that has debt.
Students who found this section tricky usually go back to Controlling, where the same idea is built up from scratch.
Factors Affecting Capital Structure
This is one of the most heavily examined lists in the whole book. Learn it properly once and it will serve you in 3-mark, 4-mark and case-based questions alike. I have written each factor with the reasoning attached, because a factor without a reason earns half a mark at best.
- Cash flow position. Debt should only be taken on if the firm can generate enough cash to service interest and repay principal. Steady, healthy cash flows support more debt.
- Interest coverage ratio (ICR). Calculated as EBIT ÷ Interest. A higher ratio means the firm can comfortably meet its interest obligations, so it can afford more debt. It has a limitation, though: it ignores repayment of the principal.
- Debt service coverage ratio (DSCR). This improves on ICR by including principal repayment as well. A higher DSCR means the firm can take on more debt.
- Return on investment (ROI). If ROI is higher than the rate of interest, the firm can profitably use debt and trade on equity. If ROI is lower, debt should be avoided.
- Cost of debt. A firm that can borrow cheaply will use more debt. A high borrowing rate makes debt unattractive.
- Tax rate. Interest is a deductible expense, so a higher tax rate makes debt effectively cheaper and more attractive.
- Cost of equity. As a firm takes on more debt, the financial risk borne by equity shareholders rises, and they begin demanding a higher return. Beyond a point this pushes the share price down — which is why debt cannot simply be increased forever.
- Floatation costs. Raising money always costs something. A public issue of shares is generally far more expensive to arrange than taking a loan, and this influences the choice.
- Risk consideration. Total business risk depends on both operating risk (from fixed operating costs) and financial risk (from fixed financial costs). If operating risk is already high, the firm should keep financial risk low by using less debt.
- Flexibility. A firm should not exhaust its borrowing capacity, so that it retains the ability to raise debt in an emergency. Borrowing to the maximum today leaves no cushion tomorrow.
- Control. Fresh equity dilutes the promoters’ control, while debt does not. Promoters wanting to retain control prefer debt.
- Regulatory framework. Every source of finance operates within legal and regulatory norms, and these must be complied with.
- Stock market conditions. During a bull run investors take risk happily and equity issues sell well; in a depressed market firms turn to debt instead.
- Capital structure of other companies. Firms often look at industry norms, since debt-equity ratios vary a lot from one industry to another. Straying too far from the industry standard invites questions from investors.
Exam Tip — how to pick the right four out of fourteen You will almost never be asked for all fourteen. Read the case for the clue words. “Profits fluctuate wildly” points to cash flow position and risk consideration. “Promoters do not want outsiders” points to control. “The company earns 20% while banks lend at 11%” points to ROI and cost of debt. “Tax rate has been raised” points to tax rate. Match the clue, then explain. That is the whole technique.
Example 12 — choosing between three plans (board-style, 6 marks)
Question: Meridian Tools Ltd requires ₹50,00,000 for a new unit. It expects a return on investment of 20%. Debt is available at 10%. The tax rate is 30% and equity shares have a face value of ₹10. Compute EPS under the following plans and advise the company.
Plan I: entirely equity. Plan II: ₹25,00,000 equity + ₹25,00,000 debt. Plan III: ₹20,00,000 equity + ₹30,00,000 debt.
Step 1 — EBIT (same for all three plans).
20% of ₹50,00,000 = ₹10,00,000
Step 2 — the working, plan by plan.
Plan I: shares = 5,00,000; interest = Nil; EBT = ₹10,00,000; tax = ₹3,00,000; PAT = ₹7,00,000; EPS = ₹7,00,000 ÷ 5,00,000 = ₹1.40
Plan II: shares = 2,50,000; interest = 10% of ₹25,00,000 = ₹2,50,000; EBT = ₹7,50,000; tax = ₹2,25,000; PAT = ₹5,25,000; EPS = ₹5,25,000 ÷ 2,50,000 = ₹2.10
Plan III: shares = 2,00,000; interest = 10% of ₹30,00,000 = ₹3,00,000; EBT = ₹7,00,000; tax = ₹2,10,000; PAT = ₹4,90,000; EPS = ₹4,90,000 ÷ 2,00,000 = ₹2.45
Step 3 — advice.
EPS is highest under Plan III at ₹2.45, so on pure EPS grounds Plan III should be selected. The reason is that ROI (20%) comfortably exceeds the cost of debt (10%), so every extra rupee of debt adds to equity shareholders’ earnings — this is trading on equity.
Step 4 — the sentence that earns the last mark.
“However, Plan III also carries the highest financial risk, since a fixed interest burden of ₹3,00,000 must be met even in a poor year. The company should adopt Plan III only if its cash flows are stable and its interest coverage remains adequate.” Interest coverage under Plan III = ₹10,00,000 ÷ ₹3,00,000 = 3.33 times, which is acceptable but noticeably thinner than Plan II’s ₹10,00,000 ÷ ₹2,50,000 = 4 times.
Examiners reward the candidate who computes correctly and flags the risk. Never stop at the arithmetic.
Plan I: entirely equity. Plan II: ₹25,00,000 equity + ₹25,00,000 debt. Plan III: ₹20,00,000 equity + ₹30,00,000 debt.
Step 1 — EBIT (same for all three plans).
20% of ₹50,00,000 = ₹10,00,000
Step 2 — the working, plan by plan.
Plan I: shares = 5,00,000; interest = Nil; EBT = ₹10,00,000; tax = ₹3,00,000; PAT = ₹7,00,000; EPS = ₹7,00,000 ÷ 5,00,000 = ₹1.40
Plan II: shares = 2,50,000; interest = 10% of ₹25,00,000 = ₹2,50,000; EBT = ₹7,50,000; tax = ₹2,25,000; PAT = ₹5,25,000; EPS = ₹5,25,000 ÷ 2,50,000 = ₹2.10
Plan III: shares = 2,00,000; interest = 10% of ₹30,00,000 = ₹3,00,000; EBT = ₹7,00,000; tax = ₹2,10,000; PAT = ₹4,90,000; EPS = ₹4,90,000 ÷ 2,00,000 = ₹2.45
Step 3 — advice.
EPS is highest under Plan III at ₹2.45, so on pure EPS grounds Plan III should be selected. The reason is that ROI (20%) comfortably exceeds the cost of debt (10%), so every extra rupee of debt adds to equity shareholders’ earnings — this is trading on equity.
Step 4 — the sentence that earns the last mark.
“However, Plan III also carries the highest financial risk, since a fixed interest burden of ₹3,00,000 must be met even in a poor year. The company should adopt Plan III only if its cash flows are stable and its interest coverage remains adequate.” Interest coverage under Plan III = ₹10,00,000 ÷ ₹3,00,000 = 3.33 times, which is acceptable but noticeably thinner than Plan II’s ₹10,00,000 ÷ ₹2,50,000 = 4 times.
Examiners reward the candidate who computes correctly and flags the risk. Never stop at the arithmetic.
Fixed Capital And What Decides Its Size
Concept. Fixed capital is the money invested in fixed assets — land, buildings, plant and machinery, vehicles, furniture — assets that stay with the business for many years and are not meant for resale. Because these funds are locked in for a long period, fixed capital must be financed from long-term sources: equity, retained earnings, debentures, long-term loans.
Why the source must be long-term. Think of a family buying a house with a one-year loan. The house will serve them for forty years, but the loan falls due in twelve months, so they must scramble. Businesses face the same trap. Funding a twenty-year machine with a six-month overdraft is how otherwise healthy firms collapse. Match the life of the asset with the life of the finance — that principle, all by itself, answers a lot of questions.
Factors affecting the requirement of fixed capital
- Nature of business. A manufacturing concern needs heavy plant and machinery; a trading concern mostly needs a shop and shelves. Manufacturing therefore requires far more fixed capital.
- Scale of operations. A large organisation operating at a large scale needs bigger plant, more buildings and more machines than a small one.
- Choice of technique. A capital-intensive firm relies on machines and needs a great deal of fixed capital. A labour-intensive firm relies on people and needs much less.
- Technology upgradation. In industries where assets become obsolete quickly, machines must be replaced often, raising the fixed capital requirement.
- Growth prospects. A company expecting higher demand builds capacity ahead of time, which means investing in fixed assets earlier and in larger measure.
- Diversification. A firm entering a new line of business needs additional fixed assets for that line, raising the requirement.
- Financing alternatives. Facilities such as leasing let a firm use an asset by paying rentals instead of buying it outright, which reduces the fixed capital needed.
- Level of collaboration. When firms collaborate — sharing facilities, ancillary arrangements, joint ventures — each partner needs less fixed capital of its own.
Example 13 — the same rupees, two very different businesses (4 marks)
Consider two firms in the same town.
Firm P — a steel fabrication unit. Total capital employed ₹80,00,000, of which ₹60,00,000 sits in land, sheds, cutting machines and a crane.
Fixed capital as a share of total = ₹60,00,000 ÷ ₹80,00,000 × 100 = 75%
Firm Q — a garment retail store. Total capital employed ₹40,00,000, of which only ₹5,00,000 is in fittings, air-conditioning and a delivery scooter. The rest is stock and cash.
Fixed capital as a share of total = ₹5,00,000 ÷ ₹40,00,000 × 100 = 12.5%
Explain the difference (this is the actual answer):
(i) Nature of business. P is a manufacturing concern and must own plant and machinery. Q is a trading concern that only buys and resells, so it needs very little in the way of fixed assets.
(ii) Choice of technique. P is capital-intensive — its output depends on machines. Q is labour-intensive, depending mainly on sales staff.
(iii) Technology upgradation. P’s cutting machines face obsolescence and periodic replacement; Q’s shop fittings do not change nearly as often.
(iv) Financing alternatives. Q leases its showroom instead of buying it, which keeps fixed capital low. P owns its land because a fabrication shed cannot easily be rented.
Notice the shape of a good 4-mark answer: four named factors, one line of explanation each, every one tied back to the two firms. No padding.
Firm P — a steel fabrication unit. Total capital employed ₹80,00,000, of which ₹60,00,000 sits in land, sheds, cutting machines and a crane.
Fixed capital as a share of total = ₹60,00,000 ÷ ₹80,00,000 × 100 = 75%
Firm Q — a garment retail store. Total capital employed ₹40,00,000, of which only ₹5,00,000 is in fittings, air-conditioning and a delivery scooter. The rest is stock and cash.
Fixed capital as a share of total = ₹5,00,000 ÷ ₹40,00,000 × 100 = 12.5%
Explain the difference (this is the actual answer):
(i) Nature of business. P is a manufacturing concern and must own plant and machinery. Q is a trading concern that only buys and resells, so it needs very little in the way of fixed assets.
(ii) Choice of technique. P is capital-intensive — its output depends on machines. Q is labour-intensive, depending mainly on sales staff.
(iii) Technology upgradation. P’s cutting machines face obsolescence and periodic replacement; Q’s shop fittings do not change nearly as often.
(iv) Financing alternatives. Q leases its showroom instead of buying it, which keeps fixed capital low. P owns its land because a fabrication shed cannot easily be rented.
Notice the shape of a good 4-mark answer: four named factors, one line of explanation each, every one tied back to the two firms. No padding.
Good to Know — the two factors students always forget Almost everyone remembers nature of business, scale of operations and technique. The two that regularly go missing are financing alternatives (leasing reduces fixed capital) and level of collaboration (sharing facilities reduces it too). Write those two and you instantly look better prepared than the average script.
Revising the full unit? Read our chapter notes on Financial Markets next — the two chapters are regularly linked in board questions.
Working Capital And What Decides Its Size
Coral = actual cash; green = money locked up in current assets. The longer this loop takes, the more working capital the firm must keep.
Concept. Working capital is the money a business needs for its day-to-day operations — money tied up in raw material, in half-finished goods, in stock waiting to be sold, in customers who have not paid yet, and in cash for wages, electricity and rent.
Two versions of the term exist, and you should know both:
- Gross working capital = total investment in current assets.
- Net working capital = current assets − current liabilities. This is the figure normally meant when someone says “working capital”, because part of your current assets are effectively funded by suppliers who let you pay later.
Why the operating cycle above matters so much. Follow the diagram once more, slowly. You spend cash on raw material. That material sits in the store for a while. It goes into production and becomes work in progress. It comes out as finished goods and waits for a buyer. A buyer takes it on credit, so now it is a debtor. Finally the debtor pays and you have cash again. Every day of that loop is a day your money is unavailable — and yet wages and electricity bills keep arriving. Working capital is simply the cushion that keeps the business running while the loop completes.
Factors affecting the requirement of working capital
- Nature of business. A trading or service concern needs little working capital because its cycle is short. A manufacturing concern needs a great deal, because raw material must be converted before anything can be sold.
- Scale of operations. Larger scale means bigger inventories and more debtors, so more working capital.
- Business cycle. In a boom, production and sales rise and more working capital is needed. In a depression, the requirement falls.
- Seasonal factors. In the peak season activity is high and working capital needs peak with it; in the lean season the requirement drops sharply.
- Production cycle. The longer the time between raw material entering and finished goods emerging, the more working capital is blocked in the process.
- Credit allowed. A liberal credit policy towards customers means more money stuck in debtors, so more working capital is required.
- Credit availed. If suppliers allow generous credit, part of the firm’s needs are financed by them and less working capital is required.
- Operating efficiency. Efficient firms turn over inventory faster and collect from debtors sooner, shortening the cycle and reducing the requirement.
- Availability of raw material. If material is easily and quickly available, small stocks suffice. If it takes long to arrive, large buffer stocks — and more working capital — are needed.
- Growth prospects. A firm planning higher levels of activity must build up inventories and capacity in advance, raising its working capital needs.
- Level of competition. Stiff competition forces firms to hold more finished goods for prompt delivery and to offer longer credit, both of which raise the requirement.
- Inflation. When prices rise, the same physical quantity of material and the same wage bill cost more, so the rupee requirement of working capital goes up.
Example 14 — measuring the operating cycle and the money it locks up
A manufacturer reports the following average holding periods:
Raw material in store 30 days · Work in progress 15 days · Finished goods 20 days · Credit given to customers 45 days · Credit received from suppliers 40 days.
Its annual operating cost is ₹73,00,000. Assume a 365-day year.
Step 1 — gross operating cycle. Add up every stage in which money is tied up:
30 + 15 + 20 + 45 = 110 days
Step 2 — net operating cycle. Subtract the credit the firm itself enjoys, because for those days the supplier is funding the business, not the firm:
110 − 40 = 70 days
Step 3 — cost per day.
₹73,00,000 ÷ 365 = ₹20,000 per day
Step 4 — working capital needed.
₹20,000 × 70 days = ₹14,00,000
Now the interesting part. Suppose the firm improves operating efficiency and cuts the finished-goods holding period from 20 days to 10 days. The new gross cycle is 30 + 15 + 10 + 45 = 100 days, so the net cycle becomes 100 − 40 = 60 days, and the requirement falls to ₹20,000 × 60 = ₹12,00,000. The firm has released ₹2,00,000 of cash without borrowing a single rupee — just by selling faster. That is exactly what the factor “operating efficiency” means in practice.
Raw material in store 30 days · Work in progress 15 days · Finished goods 20 days · Credit given to customers 45 days · Credit received from suppliers 40 days.
Its annual operating cost is ₹73,00,000. Assume a 365-day year.
Step 1 — gross operating cycle. Add up every stage in which money is tied up:
30 + 15 + 20 + 45 = 110 days
Step 2 — net operating cycle. Subtract the credit the firm itself enjoys, because for those days the supplier is funding the business, not the firm:
110 − 40 = 70 days
Step 3 — cost per day.
₹73,00,000 ÷ 365 = ₹20,000 per day
Step 4 — working capital needed.
₹20,000 × 70 days = ₹14,00,000
Now the interesting part. Suppose the firm improves operating efficiency and cuts the finished-goods holding period from 20 days to 10 days. The new gross cycle is 30 + 15 + 10 + 45 = 100 days, so the net cycle becomes 100 − 40 = 60 days, and the requirement falls to ₹20,000 × 60 = ₹12,00,000. The firm has released ₹2,00,000 of cash without borrowing a single rupee — just by selling faster. That is exactly what the factor “operating efficiency” means in practice.
Example 15 — net working capital, and a case to reason through
A firm’s balance sheet shows current assets of ₹18,00,000 (stock ₹9,00,000, debtors ₹7,00,000, cash ₹2,00,000) and current liabilities of ₹6,00,000.
Gross working capital = total current assets = ₹18,00,000
Net working capital = ₹18,00,000 − ₹6,00,000 = ₹12,00,000
Current ratio = ₹18,00,000 ÷ ₹6,00,000 = 3 : 1
The case: This firm makes woollen blankets and sells almost everything between October and January. Which factors are driving its working capital requirement, and what would you advise?
Reasoned answer.
(i) Seasonal factors. Sales are concentrated in four months, so stock must be built up through the monsoon while no money comes in. This is the single biggest driver here.
(ii) Nature of business. It is a manufacturing concern, so raw wool must be converted before any sale — a much longer cycle than a trading firm would face.
(iii) Credit allowed. ₹7,00,000 sitting in debtors is a large share of current assets, suggesting a fairly liberal credit policy.
Advice: the firm should arrange short-term finance seasonally rather than keeping ₹12,00,000 blocked all year, and should tighten collection from debtors, since a current ratio of 3 : 1 suggests more is tied up in current assets than is strictly needed. Idle working capital, remember, is not safety — it is a cost.
Gross working capital = total current assets = ₹18,00,000
Net working capital = ₹18,00,000 − ₹6,00,000 = ₹12,00,000
Current ratio = ₹18,00,000 ÷ ₹6,00,000 = 3 : 1
The case: This firm makes woollen blankets and sells almost everything between October and January. Which factors are driving its working capital requirement, and what would you advise?
Reasoned answer.
(i) Seasonal factors. Sales are concentrated in four months, so stock must be built up through the monsoon while no money comes in. This is the single biggest driver here.
(ii) Nature of business. It is a manufacturing concern, so raw wool must be converted before any sale — a much longer cycle than a trading firm would face.
(iii) Credit allowed. ₹7,00,000 sitting in debtors is a large share of current assets, suggesting a fairly liberal credit policy.
Advice: the firm should arrange short-term finance seasonally rather than keeping ₹12,00,000 blocked all year, and should tighten collection from debtors, since a current ratio of 3 : 1 suggests more is tied up in current assets than is strictly needed. Idle working capital, remember, is not safety — it is a cost.
Common Mistake — “credit allowed” and “credit availed” written the wrong way round Credit allowed is what you give to your customers, and giving more increases your working capital need. Credit availed is what your suppliers give to you, and receiving more decreases it. Students swap these two constantly. If it helps: allowed goes out, availed comes in.
Quick Revision And Exam Strategy
You have now covered every part of the CBSE Unit 9 syllabus. Before the worksheet, here is the whole chapter compressed into one table you can revise from on the morning of the exam.
| Basis | Fixed Capital | Working Capital |
|---|---|---|
| Meaning | Funds invested in fixed assets | Funds invested in current assets for daily operations |
| Duration of use | Long term, several years | Short term, usually within one year |
| Source of finance | Long-term sources: equity, debentures, long-term loans | Short-term sources: trade credit, bank overdraft, cash credit |
| Liquidity | Low — hard to convert into cash quickly | High — converts back into cash within the operating cycle |
| Reversibility | Very difficult and costly to reverse | Comparatively easy to adjust up or down |
| Typical example | A ₹60,00,000 machine in a fabrication unit | Stock of raw wool before the winter season |
Four habits that lift your score in this chapter
- Always show the format in a numerical. Write EBIT, then Less: Interest, then EBT, then Less: Tax, then PAT, then Number of shares, then EPS. Step marks are given even if the final figure slips.
- Compare ROI with the interest rate before you calculate anything. That single glance tells you whether debt will raise or lower EPS, so you already know what your answer should look like.
- In a case question, quote the case. Naming a factor gets you part marks; naming it and pointing to the line in the case that proves it gets you the full mark.
- Learn the factor lists as lists, not paragraphs. Working capital has twelve factors, capital structure fourteen, fixed capital eight. Recite them in a fixed order every day and they become automatic.
Example 16 — a full case walk-through (6 marks)
The case: “Anvi runs Kesar Foods Ltd, a spice-processing company. Profits have been steady for six years. The company earns a return on investment of 19%, while term loans are available from banks at 11%. Anvi and her brother hold 62% of the shares and are anxious not to lose control. The company now needs ₹2 crore to set up a second processing line, and it also wants to keep some borrowing capacity free in case a competitor’s plant comes up for sale next year. The board has proposed raising the entire ₹2 crore through a fresh public issue of equity.”
(a) Should the company follow the board’s proposal? Give reasons.
No. A largely equity-based plan is not the best choice here, for three reasons drawn straight from the case:
(i) Return on investment. ROI at 19% is comfortably above the 11% cost of debt, so borrowing would allow the company to trade on equity and raise EPS.
(ii) Control. A fresh public issue would dilute the promoters’ 62% holding, which the case explicitly says they wish to protect. Debt carries no voting rights.
(iii) Cash flow position. Six years of steady profits mean the company can service interest reliably, which is the basic precondition for taking on debt.
(b) Is there any factor that argues for caution?
Yes — flexibility. The case says the company wants to keep borrowing capacity free for a possible acquisition next year. So it should not borrow the entire ₹2 crore either. A sensible answer is a mix: fund a substantial part through debt to capture the ROI-interest gap and protect control, while leaving headroom for next year’s opportunity.
(c) Which financial decision is being taken here?
The financing decision, and specifically the capital structure decision, since it concerns the proportion of debt to equity in long-term funds.
How the marks fall: roughly 3 marks for the three supporting factors with reasons, 2 marks for spotting flexibility and recommending a mix rather than an extreme, 1 mark for correctly naming the decision. Students who simply write “use debt because it is cheaper” collect 1 mark out of 6. The marks are in the reasoning, not the verdict.
(a) Should the company follow the board’s proposal? Give reasons.
No. A largely equity-based plan is not the best choice here, for three reasons drawn straight from the case:
(i) Return on investment. ROI at 19% is comfortably above the 11% cost of debt, so borrowing would allow the company to trade on equity and raise EPS.
(ii) Control. A fresh public issue would dilute the promoters’ 62% holding, which the case explicitly says they wish to protect. Debt carries no voting rights.
(iii) Cash flow position. Six years of steady profits mean the company can service interest reliably, which is the basic precondition for taking on debt.
(b) Is there any factor that argues for caution?
Yes — flexibility. The case says the company wants to keep borrowing capacity free for a possible acquisition next year. So it should not borrow the entire ₹2 crore either. A sensible answer is a mix: fund a substantial part through debt to capture the ROI-interest gap and protect control, while leaving headroom for next year’s opportunity.
(c) Which financial decision is being taken here?
The financing decision, and specifically the capital structure decision, since it concerns the proportion of debt to equity in long-term funds.
How the marks fall: roughly 3 marks for the three supporting factors with reasons, 2 marks for spotting flexibility and recommending a mix rather than an extreme, 1 mark for correctly naming the decision. Students who simply write “use debt because it is cheaper” collect 1 mark out of 6. The marks are in the reasoning, not the verdict.
Key Idea — the chapter in one breath Financial management decides where money goes (investment), where money comes from (financing) and how much money goes home (dividend). Financial planning is the thinking that happens before all three. Capital structure is the answer to the second question, and fixed and working capital are the two halves of the answer to the first. That is the entire unit.
Practice Worksheet
Cover the answers. Attempt each question on paper first, in full sentences, exactly as you would in the exam. Only then click to reveal. Marks are shown so you can judge how much to write — roughly 25 to 30 words per mark is a good rule.
Q1. Why is maximisation of shareholders’ wealth considered a better objective than maximisation of profit? (3 marks)
Wealth maximisation is superior for three reasons. (i) It accounts for the timing of returns. A rupee received today is worth more than a rupee received after five years, and profit figures ignore this entirely. (ii) It accounts for risk. Two firms may report the same profit while one earns it far more reliably; the market price of the share reflects that difference, profit does not. (iii) It discourages short-sighted behaviour. A firm can inflate this year’s profit by cutting maintenance, quality or training, which raises profit today and destroys value tomorrow. Since wealth maximisation is measured by the market price of the equity share, it captures the long-term consequences that a single year’s profit figure hides.
Q2. A company is deciding whether to buy a new packaging machine, whether to fund it by a loan or a share issue, and how much of this year’s profit to distribute. Name each decision and state one factor affecting each. (3 marks)
(i) Buying the machine — investment decision (specifically a long-term or capital budgeting decision, since funds are locked into a fixed asset for years). A factor affecting it: the cash flows of the project, that is, how much money the machine will bring in over its life against what it costs.
(ii) Loan versus share issue — financing decision. A factor affecting it: control considerations, since issuing fresh shares dilutes existing owners’ control while a loan does not.
(iii) How much profit to distribute — dividend decision. A factor affecting it: growth opportunities, because a company with attractive expansion plans retains more profit and pays out less.
(ii) Loan versus share issue — financing decision. A factor affecting it: control considerations, since issuing fresh shares dilutes existing owners’ control while a loan does not.
(iii) How much profit to distribute — dividend decision. A factor affecting it: growth opportunities, because a company with attractive expansion plans retains more profit and pays out less.
Q3. “Financial planning is as much about not raising too much money as it is about not raising too little.” Explain this statement. (4 marks)
Financial planning has two objectives, and the statement points to both.
(i) Ensuring availability of funds when required. If funds fall short, production halts, wages go unpaid, and opportunities are lost. Planning estimates how much will be needed and when, so this does not happen.
(ii) Ensuring the firm does not raise resources unnecessarily. This is the half most people overlook. Surplus funds do not sit harmlessly — borrowed surplus attracts interest on money that earns nothing, and surplus equity dilutes ownership without producing extra returns. Either way profitability falls.
Illustration. A firm needing ₹3,00,000 that borrows ₹5,00,000 at 10% pays ₹50,000 of interest a year while only ₹3,00,000 is working, so ₹20,000 of that interest buys nothing at all.
Conclusion. Good financial planning aims at the right amount of funds at the right time, not the maximum amount available. Both shortage and surplus are planning failures.
(i) Ensuring availability of funds when required. If funds fall short, production halts, wages go unpaid, and opportunities are lost. Planning estimates how much will be needed and when, so this does not happen.
(ii) Ensuring the firm does not raise resources unnecessarily. This is the half most people overlook. Surplus funds do not sit harmlessly — borrowed surplus attracts interest on money that earns nothing, and surplus equity dilutes ownership without producing extra returns. Either way profitability falls.
Illustration. A firm needing ₹3,00,000 that borrows ₹5,00,000 at 10% pays ₹50,000 of interest a year while only ₹3,00,000 is working, so ₹20,000 of that interest buys nothing at all.
Conclusion. Good financial planning aims at the right amount of funds at the right time, not the maximum amount available. Both shortage and surplus are planning failures.
Q4. Explain trading on equity. State the condition under which it benefits equity shareholders and the condition under which it harms them. (4 marks)
Meaning. Trading on equity refers to the practice of deliberately including debt in the capital structure so as to increase the earnings per share of the equity shareholders. It works because debt carries a fixed rate of interest, so any surplus the borrowed funds earn above that fixed rate belongs entirely to the equity shareholders. It is also helped by the fact that interest is a tax-deductible expense.
When it benefits. When the return on investment is higher than the rate of interest on debt. The borrowed money then earns more than it costs, and the surplus raises EPS.
When it harms. When the return on investment is lower than the rate of interest. The shortfall must be met out of the equity shareholders’ share of profits, so EPS falls. At the point where ROI exactly equals the interest rate, EPS is unaffected.
The caution. Even when it works, trading on equity raises financial risk, because interest must be paid whether or not a profit is earned. It suits firms with stable, predictable cash flows.
When it benefits. When the return on investment is higher than the rate of interest on debt. The borrowed money then earns more than it costs, and the surplus raises EPS.
When it harms. When the return on investment is lower than the rate of interest. The shortfall must be met out of the equity shareholders’ share of profits, so EPS falls. At the point where ROI exactly equals the interest rate, EPS is unaffected.
The caution. Even when it works, trading on equity raises financial risk, because interest must be paid whether or not a profit is earned. It suits firms with stable, predictable cash flows.
Q5. Vanya Ceramics Ltd needs ₹30,00,000. Expected return on investment is 18%, debt is available at 12%, tax rate is 40%, and equity shares are of ₹10 each. Calculate EPS under Plan A (entirely equity) and Plan B (half equity, half debt) and advise the company. (6 marks)
Step 1 — EBIT, the same under both plans.
18% of ₹30,00,000 = ₹5,40,000
Step 2 — Plan A (all equity).
Shares = ₹30,00,000 ÷ ₹10 = 3,00,000
Interest = Nil, EBT = ₹5,40,000
Tax at 40% = ₹2,16,000
PAT = ₹5,40,000 − ₹2,16,000 = ₹3,24,000
EPS = ₹3,24,000 ÷ 3,00,000 = ₹1.08
Step 3 — Plan B (₹15,00,000 equity + ₹15,00,000 debt at 12%).
Shares = ₹15,00,000 ÷ ₹10 = 1,50,000
Interest = 12% of ₹15,00,000 = ₹1,80,000
EBT = ₹5,40,000 − ₹1,80,000 = ₹3,60,000
Tax at 40% = ₹1,44,000
PAT = ₹3,60,000 − ₹1,44,000 = ₹2,16,000
EPS = ₹2,16,000 ÷ 1,50,000 = ₹1.44
Step 4 — advice. Plan B gives a higher EPS (₹1.44 against ₹1.08, a gain of ₹0.36 per share) and should be preferred. The reason is that ROI at 18% exceeds the 12% cost of debt, so the company can profitably trade on equity. Note that PAT actually falls from ₹3,24,000 to ₹2,16,000; EPS still rises because the number of shares halves.
Caution to add: Plan B commits the company to ₹1,80,000 of interest every year regardless of profit, so it is advisable only if cash flows are stable.
18% of ₹30,00,000 = ₹5,40,000
Step 2 — Plan A (all equity).
Shares = ₹30,00,000 ÷ ₹10 = 3,00,000
Interest = Nil, EBT = ₹5,40,000
Tax at 40% = ₹2,16,000
PAT = ₹5,40,000 − ₹2,16,000 = ₹3,24,000
EPS = ₹3,24,000 ÷ 3,00,000 = ₹1.08
Step 3 — Plan B (₹15,00,000 equity + ₹15,00,000 debt at 12%).
Shares = ₹15,00,000 ÷ ₹10 = 1,50,000
Interest = 12% of ₹15,00,000 = ₹1,80,000
EBT = ₹5,40,000 − ₹1,80,000 = ₹3,60,000
Tax at 40% = ₹1,44,000
PAT = ₹3,60,000 − ₹1,44,000 = ₹2,16,000
EPS = ₹2,16,000 ÷ 1,50,000 = ₹1.44
Step 4 — advice. Plan B gives a higher EPS (₹1.44 against ₹1.08, a gain of ₹0.36 per share) and should be preferred. The reason is that ROI at 18% exceeds the 12% cost of debt, so the company can profitably trade on equity. Note that PAT actually falls from ₹3,24,000 to ₹2,16,000; EPS still rises because the number of shares halves.
Caution to add: Plan B commits the company to ₹1,80,000 of interest every year regardless of profit, so it is advisable only if cash flows are stable.
Q6. Explain any four factors that a company should consider before deciding its capital structure. (4 marks)
(i) Cash flow position. Debt brings a compulsory obligation to pay interest and repay principal. A company should take on debt only if it is confident of generating enough cash to meet these payments even in a weak year.
(ii) Return on investment. If ROI exceeds the rate of interest, debt raises EPS through trading on equity and more debt is justified. If ROI is below the interest rate, debt reduces EPS and should be avoided.
(iii) Tax rate. Interest is a deductible expense while dividend is not, so a higher tax rate lowers the effective cost of debt and makes it more attractive.
(iv) Control. Issuing fresh equity brings in new shareholders with voting rights and dilutes the control of existing owners. Debenture holders and lenders have no voting rights, so promoters who wish to retain control lean towards debt.
(Other acceptable factors include flexibility, floatation cost, cost of equity, interest coverage ratio, risk consideration, stock market conditions and regulatory framework.)
(ii) Return on investment. If ROI exceeds the rate of interest, debt raises EPS through trading on equity and more debt is justified. If ROI is below the interest rate, debt reduces EPS and should be avoided.
(iii) Tax rate. Interest is a deductible expense while dividend is not, so a higher tax rate lowers the effective cost of debt and makes it more attractive.
(iv) Control. Issuing fresh equity brings in new shareholders with voting rights and dilutes the control of existing owners. Debenture holders and lenders have no voting rights, so promoters who wish to retain control lean towards debt.
(Other acceptable factors include flexibility, floatation cost, cost of equity, interest coverage ratio, risk consideration, stock market conditions and regulatory framework.)
Q7. Distinguish between fixed capital and working capital on any four bases. (4 marks)
(i) Meaning. Fixed capital is the money invested in fixed assets such as land, buildings and machinery. Working capital is the money invested in current assets such as stock, debtors and cash for day-to-day operations.
(ii) Duration. Fixed capital remains locked up in the business for several years. Working capital is normally recovered within one operating cycle, usually less than a year.
(iii) Sources of finance. Fixed capital must be raised from long-term sources such as equity, debentures and long-term loans. Working capital can be financed from short-term sources such as trade credit, bank overdraft and cash credit.
(iv) Liquidity. Fixed capital has low liquidity, as fixed assets cannot be converted into cash quickly without loss. Working capital has high liquidity, since current assets convert back into cash in the normal course of business.
(ii) Duration. Fixed capital remains locked up in the business for several years. Working capital is normally recovered within one operating cycle, usually less than a year.
(iii) Sources of finance. Fixed capital must be raised from long-term sources such as equity, debentures and long-term loans. Working capital can be financed from short-term sources such as trade credit, bank overdraft and cash credit.
(iv) Liquidity. Fixed capital has low liquidity, as fixed assets cannot be converted into cash quickly without loss. Working capital has high liquidity, since current assets convert back into cash in the normal course of business.
Q8. A firm holds raw material for 25 days, work in progress for 10 days and finished goods for 15 days. It allows customers 40 days’ credit and receives 30 days’ credit from its suppliers. Its annual operating cost is ₹54,75,000. Calculate the gross operating cycle, the net operating cycle and the working capital required. Assume a 365-day year. (4 marks)
Step 1 — gross operating cycle. Add every stage in which the firm’s own money is tied up:
25 + 10 + 15 + 40 = 90 days
Step 2 — net operating cycle. Subtract the credit period the firm itself enjoys, because during those days the supplier finances the business:
90 − 30 = 60 days
Step 3 — operating cost per day.
₹54,75,000 ÷ 365 = ₹15,000 per day
Step 4 — working capital required.
₹15,000 × 60 days = ₹9,00,000
Interpretation. The firm must have ₹9,00,000 available at all times simply to keep the wheels turning. If it could collect from customers in 30 days instead of 40, the net cycle would fall to 50 days and the requirement to ₹15,000 × 50 = ₹7,50,000, releasing ₹1,50,000 of cash without any borrowing.
25 + 10 + 15 + 40 = 90 days
Step 2 — net operating cycle. Subtract the credit period the firm itself enjoys, because during those days the supplier finances the business:
90 − 30 = 60 days
Step 3 — operating cost per day.
₹54,75,000 ÷ 365 = ₹15,000 per day
Step 4 — working capital required.
₹15,000 × 60 days = ₹9,00,000
Interpretation. The firm must have ₹9,00,000 available at all times simply to keep the wheels turning. If it could collect from customers in 30 days instead of 40, the net cycle would fall to 50 days and the requirement to ₹15,000 × 50 = ₹7,50,000, releasing ₹1,50,000 of cash without any borrowing.
Q9. Ravneet manufactures woollen shawls, sells them mainly between November and February, buys raw wool from a distant state where deliveries take three weeks, and allows her dealers 60 days’ credit. Identify and explain any four factors affecting her working capital requirement. (4 marks)
(i) Seasonal factors. Sales are concentrated in four winter months, so stock must be produced and held through the rest of the year while no money is coming in. This sharply raises the working capital requirement in the run-up to the season.
(ii) Nature of business. Ravneet runs a manufacturing concern, not a trading one. Raw wool must be converted into finished shawls before any sale is possible, which lengthens the operating cycle and increases the funds tied up.
(iii) Availability of raw material. Wool comes from a distant state and takes three weeks to arrive, so she must hold a large buffer stock to avoid stoppages. Larger buffer stocks mean more working capital.
(iv) Credit allowed. Giving dealers 60 days’ credit means a substantial amount stays locked in debtors long after the goods have left the premises, further increasing the requirement.
Advice worth adding: she should arrange seasonal short-term finance rather than blocking funds all year, and consider shortening the credit period offered to dealers.
(ii) Nature of business. Ravneet runs a manufacturing concern, not a trading one. Raw wool must be converted into finished shawls before any sale is possible, which lengthens the operating cycle and increases the funds tied up.
(iii) Availability of raw material. Wool comes from a distant state and takes three weeks to arrive, so she must hold a large buffer stock to avoid stoppages. Larger buffer stocks mean more working capital.
(iv) Credit allowed. Giving dealers 60 days’ credit means a substantial amount stays locked in debtors long after the goods have left the premises, further increasing the requirement.
Advice worth adding: she should arrange seasonal short-term finance rather than blocking funds all year, and consider shortening the credit period offered to dealers.
Q10. A company earns a profit after tax of ₹15,00,000 and has 5,00,000 equity shares of ₹10 each. It declares a payout ratio of 30%. Calculate EPS, total dividend, DPS, retained earnings and the rate of dividend. Then state two factors that may have led the board to keep the payout this low. (5 marks)
Calculations.
EPS = ₹15,00,000 ÷ 5,00,000 = ₹3.00 per share
Total dividend = 30% of ₹15,00,000 = ₹4,50,000
DPS = ₹4,50,000 ÷ 5,00,000 = ₹0.90 per share (cross-check: 30% of ₹3.00 = ₹0.90)
Retained earnings = ₹15,00,000 − ₹4,50,000 = ₹10,50,000
Rate of dividend = ₹0.90 ÷ ₹10 × 100 = 9% on face value
Two possible reasons for the low payout.
(i) Growth opportunities. A company with attractive expansion plans retains a larger share of profit, because money reinvested in a high-return project builds shareholder wealth faster than a cash dividend would.
(ii) Cash flow position. Dividend must be paid in cash. Profit of ₹15,00,000 on paper does not mean ₹15,00,000 in the bank — much of it may be locked in stock and debtors, so the board may simply lack the liquidity for a larger payout.
(Contractual constraints imposed by lenders and legal constraints under the Companies Act are also acceptable answers.)
EPS = ₹15,00,000 ÷ 5,00,000 = ₹3.00 per share
Total dividend = 30% of ₹15,00,000 = ₹4,50,000
DPS = ₹4,50,000 ÷ 5,00,000 = ₹0.90 per share (cross-check: 30% of ₹3.00 = ₹0.90)
Retained earnings = ₹15,00,000 − ₹4,50,000 = ₹10,50,000
Rate of dividend = ₹0.90 ÷ ₹10 × 100 = 9% on face value
Two possible reasons for the low payout.
(i) Growth opportunities. A company with attractive expansion plans retains a larger share of profit, because money reinvested in a high-return project builds shareholder wealth faster than a cash dividend would.
(ii) Cash flow position. Dividend must be paid in cash. Profit of ₹15,00,000 on paper does not mean ₹15,00,000 in the bank — much of it may be locked in stock and debtors, so the board may simply lack the liquidity for a larger payout.
(Contractual constraints imposed by lenders and legal constraints under the Companies Act are also acceptable answers.)
Ten questions is a solid session. If you got six or seven right, that is a genuinely good first attempt at this chapter — go back to the two or three you missed and read only those sections again.
Key Idea — the only benchmark that matters Do not compare yourself with the topper of your class. Compare yourself with the version of you who sat down yesterday. One more question answered correctly than yesterday, one factor recalled that you could not recall last week — that is real progress, and it compounds far faster than you expect. Small, boring, daily improvement is how this chapter gets conquered.
Come back to this page in a week and redo the worksheet with the answers hidden. You will be surprised how much has stuck. See you at the next chapter.