Liquidation of Company

 Meaning: 

Liquidation of a company means the termination of the legal existence of a company. Under the circumstances, the assets of the company are disposed off and debts are paid, out of the amount realised from assets or from the contributions made by the members and the surplus, if any, is distributed among members in proportion to their holding.

Methods of Winding up of Companies. 

The methods of winding up of companies are: 

• Compulsory winding up by the court 
• Voluntary winding up: 
•     Member’s Voluntary winding up 
•     Creditor’s voluntary winding up 

• Voluntary winding up under the supervision of the court. 

Liquidator

When there is liquidation of a company, one or more persons are required to be appointed specially for conducting the liquidation or winding up proceedings of the company. Such a person’s are called Liquidator’s. He/She is required to realise the assets, discharge the liabilities and distribute the surplus, if any among shareholders.

Preferential Creditors

Creditor’s to whom following are due, as preferential creditors under Sec. 530 of the Companies Act. 

• All revenues, taxes, cesses and rates due from the company to the Central or a State Government or to a local authority at the relevant date and having become due and payable within the twelve months next before that date; 
• All wages or salary (including wages payable for time or piece work and salary earned wholly or in part by way of commission) of any employee, in respect of services rendered to the company and due for a period not exceeding four months within the twelve months next before the relevant date, and any compensation payable to any workman under any provisions of Chapter V A of the Industrial Disputes Act, 1947, provided the amount payable to any one claimant does not exceed ₹ 20,000.

Secured Creditors

A secured creditor is generally a bank or other asset-based lender that holds a fixed or floating charge over a business asset or assets. When a business becomes insolvent, sale of the specific asset over which security is held provides repayment for this category of creditor. 

Secured creditors rank highly when it comes to receiving payment. This is because secured creditors have a charge over assets held by the company. These assets can include property, as well as vehicles, machinery and fixtures and fittings. A secured creditor stands a higher chance than most of receiving payment following liquidation. Examples of secured creditors are banks, asset-based lenders, and finance and agreement providers. 

Secured creditors are then divided into two sub-categories, those with a fixed charge, and those with a floating charge. 

Unsecured Creditors

Unsecured creditors rank below secured creditors when it comes to receiving payment following the liquidation of a company. Unsecured creditors do not have the benefit of having a claim over a particular asset, and can include suppliers, contractors, landlords and customers. 

 Liquidators Final Statement of Account

At the time of Liquidation of a company, the liquidator realises all the assets and discharge the liabilities and capital. The statement prepared to record to such receipts and payments is called Liquidator’s Final Statement of Account. This statement is prepared after the affairs of the company are fully wound –up .  

Calculation of Liquidator’s Remuneration

A.    Where the remuneration is to be paid on assets realised:

I.            Exclude the cash as it is in realised form, if the problem has instruction of including then include with assets realised.

II.         No remuneration should be paid to liquidator on calls in arrears and call money realised.

III.       Surplus received from secured creditors must be considered in calculating liquidator’s remuneration. If the problem states that remuneration to be paid as a percentage on “Total assets realised” in such case total receipts need to be considered.

B.     Where the Remuneration is to be paid on payments made, the following points to be considered are:

I.          For calculating remuneration on payment made to unsecured creditors, preferential creditors must be considered as part of unsecured creditors.

II        Where the balance amount available in sufficient to pay unsecured creditors completely, liquidator’s remuneration on payment to unsecured creditors will be calculated using the following formula:

Amount Payable to Unsecured Creditors X Rate of Commission

100

III.   When the balance amount available is not sufficient enough to pay unsecured creditors completely, liquidator’s remuneration on payment to unsecured creditors will be calculated using the following formula:

Amount Available X Rate of Commission

100 + Rate of Commission

Leverages

In Financial Management the term “Leverage” is used to describe the firm's ability to use fixed cost assets or funds to increase the return to its equity shareholders.

James Horne has defined leverage as, " the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return."

It needs to be remembered that the fixed cost or fixed return (Interest) remains same irrespective of the level of operations.

We also need to understand that the higher degree of leverage means higher profit but also higher risk.

Broadly there are two types of leverages - 

1.  Financial Leverage, and

2. Operating Leverage

The leverage resulting from the use of fixed cost/ return sources of funds is known as Financial Leverage while the Leverage associated with employment of fixed cost assets is referred to as Operating Leverage.

Financial Leverage or Trading on Equity

The use of Long-Term fixed interest bearing debt and preference share capital along with equity share capital is called Financial Leverage or Trading on Equity

The impact of Financial Leverage can be analysed while looking at EPS (Earnings Per Share) and Return on Equity Capital.

EPS can also be calculated in a tabular form as follows –

1. Earnings Before Interest & Tax (EBIT)                   
2. Less: Interest    
3. Earnings Before Tax (EBIT - I)
4. Less: Tax @ ____% 
5. Earnings After Tax (EAT)  
6. Less: Preference Dividend
7. Earnings Available for Equity Shareholders
8. Number of Equity Shares
9. Earnings Per Share (EPS) (7 /8)

Degree of Financial Leverage (DFL)

DFL =  Percentage change in EPS

      Percentage change in EBIT

                   OR

DFL = EBIT

       EBT                EBT = EBIT - I

Operating Leverage

The Operating Leverage occurs when a firm has fixed costs which must be recovered irrespective of sales volume. The fixed costs remaining same, the percentage change in operating revenue will be more than the percentage change in sales.

In Simple words Operating Leverage is the change in Operating Profit due to change in Sales.

Operating Leverage =     Contribution   

                       Operating Profit

Where, 

Contribution = Sales - Variable Cost

Operating Profit = Sales - Variable Cost - Fixed Cost

                     OR

Operating Profit = Contribution - Fixed Cost

Some Additional Formulas needed are -

Break Even Point (BEP)  =  Fixed Cost

                           P/V Ratio

P/V Ratio = Contribution

              Sales

Capital Budgeting

 

Capital Budgeting

Meaning: Capital Budgeting is a process of long range planning involving investments of funds in long term activities whose benefits are expected over series of years. Capital budgeting is mainly used in decision making involving purchase of Assets or projects.

Classification of Capital Budgeting decisions

Capital Budgeting decisions may be classified as follows:

1.     Replacement Decisions

2.     Modernization Decisions

3.     Expansion Decisions

4.     Diversification Decisions

5.     Mutually Exclusive Decisions

6.     Accept /Reject Decisions

7.     Contingent Decisions/ Complimentary Decisions

Calculation of CFAT

Earnings before Depreciation & Tax

Less: Depreciation

Earnings before Tax

Less: Tax @ ____ %

Earnings after Tax

Add: Deprecation

Cash Flows after Taxes (CFAT)

Note: In last year if there is any receipt in form of Release of Working Capital or Sale of Scrap should be added to the CFAT of last year. In case of any Profit on Sale of Scrap the Tax on such profit should be deducted.

Traditional Methods

Pay Back Period

Pay Back Period refers to the period within which the entire cost of the project is expected to be completely recovered by way of cash inflows, cash inflow means earnings after tax but before depreciation.

Calculation of Pay Back Period

a)      Equal Annual Cash Inflows

Pay Back Period = Initial Cash Outflow
                  Annual Cash Inflows       

b)      Unequal Annual Cash Inflows

Payback period is calculated by computing cumulative cash inflows till the cumulative cash inflows become equal to initial cash outflow.

Pay Back Period = (Year upto which Cumulative CFAT is less then Cash Outflow) X                          Balance Cash flow to be recovered 

                      CFAT of Next Year

        Average Rate of Return (ARR)

This technique is also called as Accounting Rate of Return.

ARR means the Average annual yield on the project. It is found out by dividing the annual average profits after taxes by the average investments.

Average Rate of Return = Annual Average Earnings after Taxes   X 100

                           Average Investments

Annual Average Earnings After Taxes = Total Earnings after Tax + Interest
                                          Total period of project

Average Investments = (Opening Investments + Closing Investments) / 2

OR Average Investment = 1/2 (Original Cost - Salvage Value) + Salvage Value + WC

Discounting Methods

Net Present Value (NPV)

Accept/ Reject Rule

Accept if NPV > 0, Reject if NPV < 0

If NPV = 0, then the management would be indifferent as to whether to accept or reject.

NPV = PV of Cash Inflows - PV of Cash Outflows

Profitability Index (PI)

Accept/ Reject Rule

Accept if PI > 1, Reject if PI < 1

If PI = 1, then the management would be indifferent as to whether to accept or reject.

PI = PV of Cash Inflows

    PV of Cash Outflows

Internal Rate of Return (IRR)

Accept/ Reject Rule

Accept the proposal if IRR > k, Reject the proposal if IRR < k (k = Cost of Capital)

Calculation of IRR

Step 1. Calculate Fake Payback period

            Fake Payback Period =         Cash Outflows           

                                Average Annual Cash Inflows

Step 2. Find out 2 discount factors within which the above Fake Payback period lies from the Present Value of Annuity (PVAF) Table 

Step 3. Find out 2 discount rates corresponding to these above discount factors from the top row of the PVAF Table.

Step 4. Calculate NPV at both the discount rates so as to have one negative NPV and one positive NPV

Notes:

1. If both NPV's are positive, calculate again NPV at some higher discount rate so as to have negative NPV.

2. If both NPV's are negative, calculate again NPV at some lower discount rate so as to have positive NPV.

3. Repeat this process unless you get one lower rate at which NPV is positive and one higher rate at which NPV is negative.

Step 5. Calculate IRR by interpolation as follows:

IRR = Lower Discount Rate + 

                       NPV at lower rate              X (Higher Rate - Lower Rate)

              NPV at lower rate - NPV at higher rate

Introduction to Financial Management

 

Financial Management

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the Financial activities such as procurement and utilization of funds of the business. it means applying general management principles to financial resources of the business.

Scope of Financial Management

1.     Investment Decisions – This includes investment in fixed assets (called as Capital Budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions.

2.     Financial Decisions – They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.

3.     Dividend Decisions – The finance manager must take decision with regards to the net profit distribution. Net profits are generally divided into two:

a.      Dividend for shareholders – Dividend and the rate of it must be decided.

b.     Retained Profits – Amount of retained profits must be finalized which will depend upon expansion and diversification plans of the business.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of Financial resources of a concern. The objective can be –

1.     To ensure regular and adequate supply of funds to the concern.

2.     To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the shares, expectations of the shareholders.

3.     To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.

4.     Ton ensure safety of investments, i.e. funds should be invested in safe ventures so that adequate rate of return can be achieved.

5.     To plan a sound capital structure – there should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1.     Estimation of Capital requirements: A finance manager must make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations must be made in an adequate manner which increases earning capacity of the business.

2.     Determination of Capital composition: Once the estimation has been made, the capital structure has to be decided. This involves Short-Term and Long-Term debt equity analysis. This will depend upon the proportion of quity capital a company is possessing and additional funds which must be raised from outside parties.

3.     Choice of sources of funds: For additional funds to be procured, a company has many choices like –

a.      Issue of shares and debentures

b.     Loans to be taken from banks and financial institutions

c.      Public deposits to be drawn like in form of bonds.

          Choice of factor will depend on relative merits and demerits of each
          source and period of financing.

4.     Investment of Funds: The finance manager must decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible.

5.     Disposal of Surplus: The net profits decision must be made by the finance manager. This can be done in two ways:

a.      Dividend declaration – It includes identifying the rate of dividends and other benefits like bonus.

b.     Retained profits – The volume must be decided which will depend upon expansional, innovational, diversification plans of the company.

 

6.     Management of cash: Finance manager must make decisions with regards to cash management. Cash is required for many purposes like payment of wages & salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchases of raw materials, etc.

7.     Financial controls: The Finance manager has not only to plan, procure and utilize the funds but he also must exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Wealth Maximization V/s Profit Maximization

 

The key difference between Wealth and Profit Maximization is that Wealth maximization is the long term objective of the company to increase the value of the stock of the company thereby increasing shareholders wealth to attain the leadership position in the market, whereas, profit maximization is to increase the capability of earning profits in the short run to make the company survive and grow in the existing competitive market.

Difference Between Wealth & Profit Maximization

Wealth Maximization consists of a set of activities that manage the financial resources intending to increase the value of the stakeholders, whereas, Profit Maximization consists of the activities that manage the financial resources intending to increase the Profitability of the Company.

What is Wealth Maximization?

The ability of a company to increase the value of its stock for all the stakeholders is referred to as Wealth Maximization. It is a long-term goal and involves multiple external factors like sales, products, services, market share, etc. It assumes the risk and recognizes the time value of money given the business environment of the operating entity. It is mainly concerned with the long-term growth of the company and hence is concerned more about fetching the maximum chunk of the market share to attain a leadership position.

What is Profit Maximization?

The process of increasing the profit earning capability of the company is referred to as Profit Maximization. It is mainly a short-term goal and is primarily restricted to the accounting analysis of the financial year. It ignores the risk and avoids the time value of money. It is primarily concerned as to how the company will survive and grow in the existing competitive business environment.

Changing Role of Finance Manager

In the wake of fierce global competitiveness, path breaking technological advancement, increasing regulatory requirements, changes in business models, growing internalization of business and sensitivity of financial market, Indian business to survive and thrive and compete globally will have to redefine the role of their finance managers so that their focus is less on traditional finance jobs like transaction processing, budgeting and capital raising and instead more on strategy making and managing risk and ensure greater transparency in corporate reporting.

Today’s finance managers are expected not only to confine themselves to financial planning, capital raising, managing assets and monitoring with new perspectives, new approaches and new skills but also to assume the role of strategic partner and participate actively in the front – end of strategic thinking, building and reviewing business portfolio, managing risk and act as an agent among various constituencies within and outside the organization.

The basic functions of a Finance Manager are as follows –

1.      Estimating the Capital Requirements

2.      Financing or Capital Structure Decisions

3.      Utilization of Funds or Investment Decisions

4.      Disposal of Surplus or Dividend Decisions

5.      Management of Cash

6.      Financial Control

 

Relationship with Other Management Areas

1.      Relationship with Economics

2.      Relationship with Accounting

3.      Relationship with Mathematics, Statistics and QT

4.      Relationship with Other Disciplines (Marketing/ Production/ Personnel ….)

 

Agency Problem

 

In modern organization there is separation of ownership and management. The management acts on behalf of owners and is their agent. Consequently, management should act in such manner so as to maximize wealth of their principals. However, this may not happen because owners and management have different interests. Due to these reasons’ management may behave in a manner which is inconsistent with the interest of owners. These behavioural problems on the part of management lead to agency problems.

 

Organization of Finance Function

 

Mainly the finance function is divided in 2 broad areas – Controller and Treasurer

Controller (Manager -Accounts) is concerned primarily with planning accounting and control activities.

The Treasurer (Manager – Finance) is responsible mainly for financing, management of cash & receivables and investment activities.

Time Value of Money

The money which is receivable at present has more value than the money receivable in the future. The relationship that exists between the value of money receivable at present and the value of money receivable at future is referred as “Time Value of Money”.

From the above it is clear that the money at present is always more value then the same amount of money in future, that is due to Time Value of Money.

Interest:

Interest is an amount that accrues on the money borrowed / lent at present for a particular period. Interest can also be understood as the rent paid on the money or the price of using the money.

The rate at which the accrues is called as Interest Rate. Interest Rate is usually stated for a year, i.e. *% p.a., 13% p.a., etc.

 

Types of Interest

There are two types of Interest -

1. Simple Interest

2. Compound Interest

 

Simple Interest

SI is the Interest which accrues only on the principal amount of loan. That means that the interest is charged only on the original amount of money borrowed / lent. 

Simple Interest = Amount(P) X Rate of Interest(r) X Time Period (t)

                                 SI = Prt

Formula to calculate Future Value & Principal (Simple Interest Basis)

Future Value of Money (FV) = P + Prt or P (1 + rt)

Principal (P) =    FV/ (1+rt)

Compound Interest

Compound Interest is the Interest which accrues not only on the principal amount but also on the amount of Interest due. In simple words compound interest charges Interest on Interest.

Formula to calculate Future Value & Principal (Compound Interest Basis)

Future Value of Money (FV) = P X (1 + r)^t

Compound Interest (CI) = FV – Principal

Principal (P) = FV / (1 + r)^t 

Present Value

Present value is the concept that states an amount of money today is worth more than that same amount in the future. In other words, money received in the future is not worth as much as an equal amount received today. Receiving Rs.1,000 today is worth more than Rs. 1,000 five years from now.

Present value is the current value of the future sum of money, at a specified rate of return. The future cash flows would be discounted. The higher the discount rate, the lower is the present value of the future cash flows. 

In Simple words, PV is the difference between Future Value (FV) and Interest for the period. It is the FV of money discounted at a given rate of interest.

PV = FV / (1 + r)^t

Present Value Factor (PVF) = 1/ (1 + r)^t

PVF < 0 (PVF will always be less then Zero)

Future Value

Future value is what a sum of money invested today will become over time, at a given rate of interest.

FV is the sum of the Present Value of Money and the Interest accrued on it over a period of time at a rate of Interest.

FV = PV (1 + r)^t

Compound Value Factor (CVF) = (1 + r)^t

CVF > 1 (CVF will always be more than One)

Valuation of Shares

 Valuation of Shares

Methods of Valuation of Shares

1. Net Assets Basis or Intrinsic Value or Assets Backing

2.. Earning Capacity or Yield Basis or Market Value

3. Fair Value Method or Dual Method

1. Net Assets Basis or Intrinsic Value or Assets Backing

Steps to Calculate "Amount Available to Equity Shareholders"

1. Fixed  Assets (Tangible and Intangible) to be considered at their Realizable Value.

    Note: Goodwill can be calculated on Super Profit Basis. If Purchased Goodwill appears in the
               books, it should be ignored and New Valuation should be done.

2. Inventories / Stock should be taken at Current Market Price

3. Fictitious assets such as Preliminary Expenses, P & L A/c (Dr. Balance), Etc. should be ignored

4. All unrecorded Assets and Liabilities should be considered

5. From the Total Assets All Outside Liabilities should be deducted.

6. Preference Share Capital including arrears of Dividend(if any) should be deducted

     Value of Each Equity Share = Amount Available to Equity Shareholders

                                                                  No. of Equity Shares

Note: If there are both Fully Paid-up and Partly Paid-up shares, Then, The uncalled amount on Partly Paid-up shares should be added to the Total Net Assets by way of Notional Call and Notionally Convert all Partly Paid Shares in Fully Paid Shares. To get the Value of Each Equity Share the Total Funds/Amount Available for Equity Shareholders should be divided by Total Equity Share (Fully Paid + Partly Paid).

2. Yield Basis or Earning Capacity or Market Value

Under this method the shares are valued based on the rate of return the shareholder earns on his investments. The Rate of Return can be Classified as 

        a) Rate of Dividend

        b) Rate of Earning.

     Valuation based on Rate of Dividends

     

     Value of Each Equity Share =     Dividends per Share    X 100

                                                          Normal Rate of Return

                                                  

                                    or             = Rate of Dividend (Expected)     X Paid up Value per Share 

                                                          Normal Rate of Return

     Valuation based on Rate of Earnings

     

     Value of Each Equity Share =     Expected Profits    X 100

                                                             Equity Capital 

 

                                    or             = Expected Rate of Return     X Paid up Value per Share 

                                                          Normal Rate of Return

     The value of each Equity Share can also be calculated under this method by Capitalization of
     Profits

     

     Capitalized Value of Profit =         Expected Profit           X 100

                                                         Normal Rate of Return 

     Value of Each Equity Share =   Capitalized Value of Profit  X 100

                                                           Number of Equity Shares 

3. Fair Value Method or Dual Method

     There is no specific formula for calculation of Value of Shares under this method this is just a       
     simple average of Intrinsic Value and Yield Basis.

Valuation of Goodwill

Valuation of Goodwill

Factors affecting the Value of Goodwill

1.      Future Profits expected to be earned by the concern.
2.      Capital Requirements.
3.      Possibility of transfer of Goodwill.

Methods of valuing Goodwill

1.      Average Profits Methods

2.      Super Profit Method

3.      Capitalization Method

4.      Annuity Method

Let us discuss each method detail –

1.      Average Profit Method:

Goodwill under this method is calculated based on the Average Profits of Past few years. The Average Profit is multiplied by the No. of Years for which such profit is expected to be earned.

Goodwill = Average Profit X No. of Years Purchase

Average Profit =           Total Profit

                                    No. of Years

There is an extension of this method wherein the profits of each year are given weights and based on this the weighted profits are calculated.

Goodwill = Weighted Average Profit X No. of Years Purchase

Weighted Average Profit =     Total Weighted Profits

                                                      Total Weights

Note: While allotting weights we need to remember that the highest weight is to be given to the most recent year, i.e. lowest weight (1) is to be given to the oldest year.

 

2.      Super Profit Method:

Under this method FMP (Future Maintainable Profits) of the firm are compared with the Normal Profits. The amount of FMP more then the Normal Profits is known as “Super Profit”

Goodwill = Super Profit X No. of Years Purchase

Super Profit = FMP – Normal Profit

FMP = Average Profit +/- Adjustments related to future profit

Calaulation of Future Maintainable Profits
	Past Average Profits	XXX
Add:	Expenses not likely to inccur in future	XXX
	Expected New Incomes in future	XXX	XXX
Less:	New Expenses expected to be	XXX
	inccured in future	XXX
	Incomes not likely to inccur in future	XXX	XXX
	Future Maintainable Profits		XXX

 

Normal Profit = Average Capital Employed X NRR/100

NRR means Normal Rate of Return

 

Capital Employed can be calculate using either the Asset Side Approach or the

Liability Side Approach.

 

Asset Side Approach
Total Assets	XXX
(Except Goodwill &
fictitious Assets)
(-) Outside Liabilities	XXX
Capital Employed	XXX

 

Liability Side Approach
	Share Capital	XXX
	Reserve Fund	XXX
	P & L A/c	XXX
	Apprn in value of assets
	due to Revaluation	XXX	XXX
Less:	Goodwill	XXX
	Fictitious Assets	XXX
	Fall in value of assets
	due to Revaluation	XXX	XXX
	Capital Employed		XXX

 

3.      Capitalization Method:

Under this method the value of Goodwill is calculated by Capitalizing the Super Profits of the Business.

Goodwill = Super Profit X 100/NRR