Lebs209 PDF
Lebs209 PDF
Lebs209 PDF
9
LEARNING OBJECTIVES F INANCIAL M ANAGEMENT
After studying this chapter, you
TATA STEEL ACQUIRES CORUS
should be able to:
Tata Steel, the biggest steel producer
in the Indian private sector has acquired
explain the meaning of business
Corus, (formerly known as British Steel)
finance; in a deal worth $8.6 billion. This makes
Tata Steel the fifth largest steel
describe financial management; producer in the world. A financial
decision of this magnitude has
significant implicitness for both Tata
explain the role of financial
Steel and Corus as well as their
management in our enterprise; employees and shareholders. To
mention some of them:
discuss objectives of financial l Tata Steel will become the fifth
management and how they largest producer of steel in the world.
could be achieved; l Tata Steel will raise a debt of over
$ 8 billion to finance the transaction.
explain the meaning and The deal will be paid for by Tata Steel
importance of financial UK, a special purpose vehicle (SPV)
planning; set up for the purpose. This SPV will
get funds from Tata Steel routed
through a Singapore subsidiary.
state the meaning of capital Another company of the Tata group,
structure; Tata Sons Ltd., will invest $ 1 billion
dollars for preference shares along
analyse the factors affecting the with Tata Steel which will invest an
choice of an appropriate capital equal amount.
structure; l Tata Steel, the acquirer company, shall
have to arrange about 36,500 crores
of rupees to finance the take-over.
state meaning of fixed capital
l Tata Steel will have to raise this
and working capital; and
amount through debt or equity or a
combination of both. Some amount
analyse the factors affecting the may come from internal accruals also.
requirement of fixed and This financing decision will affect the
working capital. capital structure of Tata Steel.
l Tata Steel hopes to increase the
production to 40 million tonnes and
revenue to 32 billion US dollars by
2012.
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l It may affect the competitiveness of Tata Steel because the cost of production of
steel in all probability, will change.
l The dividend paying capacity of Tata Steel may be affected because of this huge
cash outflow and because of a significantly higher debt which would need to be
serviced before paying any dividends to shareholders.
l The degree of risk shall also be affected. Needless to emphasise, decisions like
this affect the future of the organisation. These decisions are almost irrevocable
after they have been formalised.
Source: The Economic Times
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Investment Decision
A firms resources are scarce in
comparison to the uses to which they
can be put. A firm, therefore, has to
choose where to invest these
resources, so that they are able to earn Wealth Maximisation Concept
the highest possible return for their
investors. The investment decision, decisions must be taken by those who
therefore, relates to how the firms understand them comprehensively. A
funds are invested in different assets. bad capital budgeting decision
Investment decision can be long- normally has the capacity to severely
term or short-term. A long-term damage the financial fortune of a
investment decision is also called a business.Short-term investment
Capital Budgeting decision. It involves decisions (also called working capital
committing the finance on a long-term decisions) are concerned with the
basis. For example, making decisions about the levels of cash,
investment in a new machine to inventory and receivables. These
replace an existing one or acquiring a decisions affect the day-to-day working
new fixed asset or opening a new of a business. These affect the liquidity
branch, etc. These decisions are very as well as profitability of a business.
crucial for any business since they Efficient cash management, inventory
affect its earning capacity in the long management and receivables
run. The size of assets, profitability and management are essential ingredients
competitiveness are all affected by of sound working capital management.
capital budgeting decisions. Moreover,
these decisions normally involve huge Factors affecting Capital
amounts of investment and are Budgeting Decision
irreversible except at a huge cost. A number of projects are often
Therefore, once made, it is often almost available to a business to invest in. But
impossible for a business to wriggle out each project has to be evaluated
of such decisions. Therefore, they need carefully and, depending upon the
to be taken with utmost care. These returns, a particular project is either
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Financial Decisions
The cost of each type of finance has to pay any dividend on equity shares.
to be estimated. Some sources may be Thus, there is some amount of financial
cheaper than others. For example, debt risk in debt financing. The overall
is considered to be the cheapest of all financial risk depends upon the
the sources, tax deductibility of interest proportion of debt in the total capital.
makes it still cheaper. Associated risk The fund raising exercise also costs
is also different for each source, e.g., it something. This cost is called
is necessary to pay interest on debt and floatation cost. It also must be
redeem the principal amount on considered while evaluating different
maturity. There is no such compulsion sources. Financing decision is, thus,
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concerned with the decisions about (d) Cash Flow Position of the Company:
how much to be raised from which A stronger cash flow position may
source. This decision determines the make debt financing more viable
overall cost of capital and the financial than funding through equity.
risk of the enterprise. (e) Fixed Operating Costs: If a
business has high fixed operating
Factors Affecting Financing
costs (e.g., building rent,
Decisions
Insurance premium, Salaries,
The financing decisions are affected by etc.), It must reduce f i x e d
various factors. Important among financing costs. Hence, lower debt
them are as follows: financing is better. Similarly, if
(a) Cost: The cost of raising funds fixed operating cost is less, more
through different sources are of debt financing may be
different. A prudent financial preferred.
manager would normally opt for a (f) Control Considerations: Issues of
source which is the cheapest. more equity may lead to dilution
(b) Risk: The risk associated with each of managements control over the
of the sources is different. business. Debt financing has no
(c) Floatation Costs: Higher the floatation such implication. Companies
cost, less attractive the source. afraid of a takeover bid would
prefer debt to equity.
Corporate India has opened its purse strings to shareholders with interim
dividends and bonus shares. At least 60 companies have declared interim dividend
or announced plans to do so in the first three weeks of January. In addition, around
12 companies have announced bonus share issues this month, about three times
more than January 2006.
There are range of things that a company can do for maximising shareholder
value and dividend is the most direct and simple form of it. Ideally companies need
to balance it up between paying cash and building value of the stock for total
shareholder returns.
This trend of dividends and bonuses is in synchronisation with the good profits
being posted by companies. Its a way of rewarding shareholders.
A number of companies have also announced plans of bonus shares for their
shareholders. Most of the companies who have already declared bonus issues or
announced that they would be taking it up in their next board meeting are small or
mid-sized companies.
Source: The Economic Times
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(g) State of Capital Market: Health of Some of the important factors are
the capital market may also affect discussed as follows:
the choice of source of fund. During (a) Amount of Earnings: Dividends are
the period when stock market is paid out of current and past
rising, more people invest in equity. earning. Therefore, earnings is a
However, depressed capital market major determinant of the decision
may make issue of equity shares about dividend.
difficult for any company. (b) Stability Earnings: Other things
remaining the same, a company
Dividend Decision having stable earning is in a better
The third important decision that position to declare higher
every financial manager has to take dividends. As against this, a
company having unstable earnings
relates to the distribution of dividend.
is likely to pay smaller dividend.
Dividend is that portion of profit
which is distributed to shareholders. (c) Stability of Dividends: Companies
The decision involved here is how generally follow a policy of
stabilising dividend per share.
much of the profit earned by company
The increase in dividends is
(after paying tax) is to be distributed
generally made when there is
to the shareholders and how much of
confidence that their earning
it should be retained in the business.
potential has gone up and not
While the dividend constitutes the just the earnings of the current
current income re-investment as year. In other words, dividend per
retained earning increases the firms share is not altered if the change
future earning capacity. The extent of in earnings is small or seen to be
retained earnings also influences the temporary in nature.
financing decision of the firm. Since (d) Growth Opportunities: Companies
the firm does not require funds to the having good growth opportunities
extent of re-invested retained retain more money out of their
earnings, the decision regarding earnings so as to finance the
dividend should be taken keeping in required investment. The dividend
view the overall objective of in growth companies is, therefore,
maximising shareholders wealth. smaller, than that in the non
growth companies.
Factors Affecting Dividend Decision (e) Cash Flow Position: The payment
How much of the profits earned by a of dividend involves an outflow of
company will be distributed as profit cash. A company may be earning
and how much will be retained in the profit but may be short on cash.
business is affected by many factors. Availability of enough cash in the
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the management may decide what share capital, preference share capital
must be done in each of these and reserves and surpluses or retained
situations. This preparation of earnings. Borrowed funds can be in the
alternative financial plans to meet form of loans, debentures, public
different situations is clearly of deposits etc. These may be borrowed
immense help in running the from banks, other financial institutions,
business smoothly. debentureholders and public.
(ii) It helps in avoiding business Capital structure refers to the mix
shocks and surprises and helps between owners and borrowed funds.
the company in preparing for the These shall be referred as equity and
future. debt in the subsequent text. It can be
(iii) If helps in co-ordinating various calculated as debt-equity ratio
business functions, e.g., sales and Debt
production functions, by providing i.e., Equity or as the proportion of
clear policies and procedures.
debt out of the total capital i.e.,
(iv) Detailed plans of action prepared
under financial planning reduce Debt
waste, duplication of efforts, and Debt + Equity .
gaps in planning.
Debt and equity differ significantly
(v) It tries to link the present with the in their cost and riskiness for the firm.
future. The cost of debt is lower than the cost of
(vi) It provides a link between equity for a firm because the lenders risk
investment and financing decisions is lower than the equity shareholders
on a continuous basis. risk, since the lender earns an assured
(vii) By spelling out detailed objectives return and repayment of capital and,
for various business segments, it therefore, they should require a lower
makes the evaluation of actual rate of return. Additionally, interest paid
performance easier. on debt is a deductible expense for
computation of tax liability whereas
CAPITAL STRUCTURE dividends are paid out of after-tax
profit. Increased use of debt, therefore,
One of the important decisions under is likely to lower the over-all cost of
financial management relates to the capital of the firm provided that the cost
financing pattern or the proportion of of equity remains unaffected. Impact
the use of different sources in raising of a change in the debt-equity ratio
funds. On the basis of ownership, the upon the earning per share is dealt with
sources of business finance can be in detail later in this chapter.
broadly classified into two categories Debt is cheaper but is more risky
viz., owners funds and borrowed for a business because the payment of
funds. Owners funds consist of equity interest and the return of principal is
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Example I
Company X Ltd.
Total Funds used Rs. 30 Lakh
Interest rate 10% p.a.
Tax rate 30%
EBIT Rs. 4 Lakh
Debt
Situation I Nil
Situation II Rs. 10 Lakh
Situation III Rs. 20 Lakh
EBIT-EPS Analysis
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Example II
Company Y Ltd.
Situation I Situation II Situation III
EBIT 2,00,000 2,00,000 2,00,000
Interest NIL 1,00,000 2,00,000
EBT 2,00,000 1,00,000 NIL
Tax 60,000 30,000 NIL
EAT 1,40,000 70,000 NIL
No. of shares of Rs.10 3,00,000 2,00,000 1,00,000
EPS 0.47 0.35 NIL
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In this example, the EPS of the flows must not only cover fixed cash
company is falling with increased use payment obligations but there must be
of debt. It is because the Companys rate sufficient buffer also. It must be kept
of return on investment (RoI) is less than in mind that a company has cash
the cost of debt. The RoI for company Y payment obligations for (i) normal
2Lakh business operations; (ii) for investment
is 100 , i.e., 6.67%, whereas in fixed assets; and (iii) for meeting the
30Lakh
the interest rate on debt is 10%. In such debt service commitments i.e., payment
cases, the use of debt reduces the EPS. of interest and repayment of principal.
This is a situation of unfavourable 2. Interest Coverage Ratio (ICR): The
financial leverage. Trading on Equity is interest coverage ratio refers to the
clearly unadvisable in such a situation. number of times earnings before
Even in case of Company X, interest and taxes of a company covers
reckless use of Trading on Equity is the interest obligation. This may be
not recommended. An increase in debt calculated as follows:
may enhance the EPS but as pointed
EBIT
out earlier, it also raises the financial ICR =
Interest
risk. Ideally, a company must choose
that risk-return combination which The higher the ratio, lower shall be
maximises shareholders wealth. The the risk of company failing to meet its
debt-equity mix that achieves it, is the interest payment obligations. However,
optimum capital structure. this ratio is not an adequate measure.
A firm may have a high EBIT but low
Factors affecting the Choice of cash balance. Apart from interest,
Capital Structure repayment obligations are also relevant.
Deciding about the capital structure
3. Debt Service Coverage Ratio
of a firm involves determining the
(DSCR): Debt Service Coverage Ratio
relative proportion of various types of takes care of the deficiencies referred
funds. This depends on various
to in the Interest Coverage Ratio (ICR).
factors. For example, debt requires
The cash profits generated by the
regular servicing. Interest payment operations are compared with the total
and repayment of principal are cash required for the service of the debt
obligatory on a business. In addition
and the preference share capital. It is
a company planning to raise debt must calculated as follows:
have sufficient cash to meet the
Profit after tax + Depreciation + Interest + Non Cash exp.
increased outflows because of higher
Pref. Div + Interest + Repayment obligation
debt. Similarly, important factors
which determine the choice of capital A higher DSCR indicates better ability
structure are as follows: to meet cash commitments and
1. Cash Flow Position: Size of consequently, the companys potential
projected cash flows must be to increase debt component in its
considered before borrowing. Cash capital structure.
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4. Return on Investment (RoI): If the beyond that point, cost of equity may
RoI of the company is higher, it can go up sharply and share price may
choose to use trading on equity to decrease inspite of increased EPS.
increase its EPS, i.e., its ability to use Consequently, for maximisation of
debt is greater. We have already shareholders wealth, debt can be used
observed in Example I that a firm can only upto a level.
use more debt to increase its EPS. 8. Floatation Costs: Process of raising
However, in Example II, use of higher resources also involves some cost.
debt is reducing the EPS. It is because Public issue of shares and debentures
the firm is earning an RoI of only requires considerable expenditure.
6.67% which lower than its cost of Getting a loan from a financial
debt. In example I the RoI is 13.33%, institution may not cost so much.
and trading on equity is profitable. It These considerations may also affect
shows that, RoI is an important the choice between debt and equity
determinant of the companys ability and hence the capital structure.
to use Trading on equity and thus the
9. Risk Consideration: As discussed
capital structure.
earlier, use of debt increases the
5. Cost of debt: A firms ability to financial risk of a business. Financial
borrow at a lower rate increases its risk refers to a position when a
capacity to employ higher debt. Thus, company is unable to meet its fixed
more debt can be used if debt can be financial charges namely interest
raised at a lower rate. payment, preference dividend and
6. Tax Rate: Since interest is a repayment obligations. Apart from the
deductible expense, cost of debt is financial risk, every business has some
affected by the tax rate. The firms in operating risk (also called business
our examples are borrowing @ 10%. risk). Business risk depends upon
Since the tax rate is 30%, the after tax fixed operating costs. Higher fixed
cost of debt is only 7%. A higher tax operating costs result in higher
rate, thus, makes debt relatively business risk and vice-versa. The total
cheaper and increases its attraction risk depends upon both the business
vis--vis equity. risk and the financial risk. If a firms
business risk is lower, its capacity to
7. Cost of Equity: Stock owners
use debt is higher and vice-versa.
expect a rate of return from the equity
which is commensurate with the risk 10. Flexibility: If a firm uses its debt
they are assuming. When a company potential to the full, it loses flexibility
increases debt, the financial risk faced to issue further debt. To maintain
by the equity holders, increases. flexibility, it must maintain some
Consequently, their desired rate of borrowing power to take care of
return may increase. It is for this unforeseen circumstances.
reason that a company can not use 11. Control: Debt normally does not
debt beyond a point. If debt is used cause a dilution of control. A public
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issue of equity may reduce the should go in for low debt. Thus, the
managements holding in the company management must know what the
and make it vulnerable to takeover. This industry norms are, whether they are
factor also influences the choice following them or deviating from them
between debt and equity especially in and adequate justification must be
companies in which the current holding there in both cases.
of management is on a lower side.
12. Regulatory Framework: Every FIXED AND WORKING CAPITAL
company operates within a regulatory Meaning
framework provided by the law e.g., Every company needs funds to finance
public issue of shares and debentures
its assets and activities. Investment is
have to be made under SEBI
required to be made in fixed assets and
guidelines. Raising funds from banks
current assets. Fixed assets are those
and other financial institutions require
which remains in the business for
fulfillment of other norms. The relative
more than one year, usually for much
ease with which these norms can, be
longer, e.g., plant and machinery,
met or the procedures completed may
furniture and fixture, land and
also have a bearing upon the choice of
building, vehicles, etc.
the source of finance.
Decision to invest in fixed assets
13. Stock Market Conditions: If the must be taken very carefully as the
stock markets are bullish, equity shares investment is usually quite large.
are more easily sold even at a higher Such decisions once taken are
price. Use of equity is often preferred irrevocable except at a huge loss.
by companies in such a situation. Such decisions are called capital
However, during a bearish phase, a budgeting decisions.
company, may find raising of equity Current assets are those assets
capital more difficult and it may opt for which, in the normal routine of the
debt. Thus, stock market conditions business, get converted into cash or
often affect the choice between the two. cash equivalents within one year, e.g.,
14. Capital Structure of other inventories, debtors, bills receivables,
Companies: A useful guideline in the etc.
capital structure planning is the debt-
equity ratios of other companies in the Management of Fixed Capital
same industry. There are usually some Fixed capital refers to investment in
industry norms which may help. Care long-term assets. Management of fixed
however must be taken that the capital involves allocation of firms
company does not follow the industry capital to different projects
norms blindly. For example, if the or assets with long-term implications for
business risk of a firm is higher, it can the business. These decisions are called
not afford the same financial risk. It investment decisions or capital
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Thus, net working capital may be larger and, therefore, larger amount of
defined as the excess of current assets working capital is required. As against
over current liabilities. this, the requirement for working
capital will be lower during the period
FACTORS A FFECTING THE WORKING of depression as the sales as well as
CAPITAL R EQUIREMENTS production will be small.
4. Seasonal Factors: Most business
1. Nature of Business: The basic
have some seasonality in their
nature of a business influences the operations. In peak season, because of
amount of working capital required. A
higher level of activity, larger amount
trading organisation usually needs a of working capital is required. As
smaller amount of working capital
against this, the level of activity as well
compared to a manufacturing as the requirement for working capital
organisation. This is because there is will be lower during the lean season.
usually no processing. Therefore, there
is no distinction between raw materials 5. Production Cycle: Production cycle
is the time span between the receipt of
and finished goods. Sales can be
effected immediately upon the receipt raw material and their conversion into
finished goods. Some businesses have
of materials, sometimes even before
a longer production cycle while some
that. In a manufacturing business,
have a shorter one. Duration and the
however, raw material needs to be
length of production cycle, affects the
converted into finished goods before
amount of funds required for raw
any sales become possible. Other
materials and expenses. Consequently,
factors remaining the same, a trading
working capital requirement is higher
business requires less working capital.
in firms with longer processing cycle
Similarly, service industries which
and lower in firms with shorter
usually do not have to maintain
processing cycle.
inventory require less working capital.
6. Credit Allowed: Different firms allow
2. Scale of Operations: For organisations different credit terms to their
which operate on a higher scale of customers. These depend upon the level
operation, the quantum of inventory and of competition that a firm faces as well
debtors required is generally high. Such as the credit worthiness of their
organisations, therefore, require large clientele. A liberal credit policy results
amount of working capital as compared in higher amount of debtors, increasing
to the organisations which operate on a the requirement of working capital.
lower scale. 7. Credit Availed: Just as a firm
3. Business Cycle: Different phases allows credit to its customers it also
of business cycles affect the may get credit from its suppliers. To
requirement of working capital by a the extent it avails the credit on
firm. In case of a boom, the sales as purchases, the working capital
well as production are likely to be requirement is reduced.
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8. Operating Efficiency: Firms 10. Growth Prospects: If the growth
manage their operations with varied potential of a concern is perceived to
degrees of efficiency. For example, a be higher, it will require larger amount
firm managing its raw materials of working capital so that it is able to
efficiently may be able to manage with meet higher production and sales
a smaller balance. This is reflected in target whenever required.
a higher inventory turnover ratio. 11. Level of Competition: Higher
Similarly, a better debtors turnover level of competitiveness may
ratio may be achieved reducing the necessitate larger stocks of finished
amount tied up in receivables. Better goods to meet urgent orders from
sales effort may reduce the average customers. This increases the working
time for which finished goods inventory capital requirement. Competition may
is held. Such efficiencies may reduce also force the firm to extend liberal
the level of raw materials, finished credit terms discussed earlier.
goods and debtors resulting in lower 12. Inflation: With rising prices,
requirement of working capital. larger amounts are required even to
9. Availability of Raw Material: If the maintain a constant volume of
raw materials and other required production and sales. The working
materials are available freely and capital requirement of a business
continuously, lower stock levels may thus, become higher with higher rate
suffice. If, however, raw materials do of inflation. It must, however, be noted
not have a record of un-interrupted that an inflation rate of 5%, does not
availability, higher stock levels may be mean that every component of
required. In addition, the time lag working capital will change by the
between the placement of order and same percentage. The actual
the actual receipt of the materials (also requirement shall depend upon the
called lead time) is also relevant. Larger rates of price change of different
the lead time, larger the quantity of components (e.g., raw material,
material to be stored and larger shall finished goods, labour cost,) Finished
be the amount of working capital goods as well as their proportion in
required. the total requirement.
K EY TERMS
Financial Management Wealth Maximisation Investment Decision
Financing Decision Dividend Decision Capital Budgeting
Working Capital Financial Planning Capital Structure
Trading on Equity
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SUMMARY
Business finance: The money required for carrying out business activities is
called business finance. Almost all business activities require some finance.
Finance is needed to establish a business, to run it, to modernise it, to expand,
and diversify it.
Financial Management: Financial Management is concerned with optimal
procurement as well as usage of finance. For optimal procurement, different
available sources of finance are identified and compared in terms of their costs
and associated risks.
Objectives and Financial Decisions The primary aim of financial management
is to maximise shareholders wealth which is referred to as the wealth
maximisation concept. The market price of a companys shares are linked to
the three basic financial decisions
Financial decision-making is concerned with three broad decisions which are
Investment Decision, Financing Decision, Dividend Decision
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EXERCISES
Objectivetype questions
1. The cheapest source of finance is:
a. debenture b. equity share capital
c. preference share d. retained earning
2. A decision to acquire a new and modern plant to upgrade an old one is a:
a. financing decision
b. working capital decision
c. investment decision
d. None of the above
3. Other things remaining the same, an increase in the tax rate on corporate
profits will:
a. make the debt relatively cheaper
b. make the debt relatively the dearer
c. have no impact on the cost of debt
d. we cant say
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5. Explain the term Trading on Equity. Why, when and how it can be used
by a company?
Case Problem
S Limited is manufacturing steel at its plant in India. It is enjoying a buoyant
demand for its products as economic growth is about 7%-8% and the demand
for steel is growing. It is planning to set up a new steel plant to cash on the
increased demand. It is estimated that it will require about
Rs. 5000 crores to set up and about Rs 500 crores of working capital to start
the new plant.
Questions
1. Describe the role and objectives of financial management for this company.
2. Explain the importance of having a financial plan for this company. Give
an imaginary plan to support your answer.
3. What are the factors which will affect the capital structure of this company?
4. Keeping in mind that it is a highly capital-intensive sector, what factors
will affect the fixed and working capital. Give reasons in support of your
answer.
Project Work
1. Pick up the annual reports of 2 or more companies engaged in the same
line of business. You can access this data on the respective website of the
companies and other sources. Compare their capital structures. Analyse
the reasons for the difference. You can also use ratio analysis for this.
Prepare a report of your findings and discuss it in the class with the help of
your teacher.
2. From the annual reports that you use in activity, analyse the working capital
of the companies. You can use short-term solvency ratios. Study the
operating cycle of the line of business you have choosen and prepare a
report as to the soundness of the working capital management of the
companies you are studying. Prepare a report of your findings and discuss
it in class with the help of your teacher.
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