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Financial Accounting A Tool for the Practising Manager in a

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									                                       Financial Management of Distribution Management
                           Distribution Reform, Upgrades and Management (DRUM) Training Program




                    Financial Accounting
A Tool for the Practising Manager in a Distribution Company
                     Pisupati Karthikeya, Emerging Markets Group, Ltd


A financial manager needs to understand the tools available to understand and manage
the finances of the company and ensure that the product and service is efficiently
produced/ delivered to ensure proper pricing to the end consumer. In the following
sections, we set out the understanding and tools required by such a manger.

1. Relationship between Finance and Accounting

Accounting provides the necessary input to other functions including finance. It
generates information/ data relating to operations/ activities of the company, which at
the end is summarised in financial statements such as Balance sheet, Profit and Loss
account and cash flow statements.

Finance function considers the input given by accounting for various financial decision
making purposes such as budgeting, service/ product costing, investments etc. In many
firms the roles are often merged and carried out by a single functionary.

SEBs had traditionally have not segregated this function, though budgets and financial
controller posts were different than that of accounts.

2. What are the major differences between the two?

a. Treatment of funds– in accounting, accrual principle/ system is used i.e. revenue or
   expense is recognised whether it has been received or paid in a particular period.
   This method is important for a company to understand its profitability in that
   accounting period, failing which it may make erroneous judgements.

   Finance concentrates on the solvency of the situation and thus may monitor the
   cash position more closely and arrange for funds to tide over any short term
   mismatch between realisability versus payablility.

   Thus a company may be profitable but not solvent in a short or medium term (a SEB
   shows profitability in its P/L, since it accounts for subsidy from Government. But in
   reality, if the subsidy is not received in cash, then the solvency of SEB is affected –
   subsidy is accounted for ~25% of the revenue realisation and shortfall affects SEBs
   cash flows)

   Another Classical example: Regulator‟s treatment of annual revenue requirement – it
   treats the revenue as 100% realisable and ignores the cash shortfall due to <100%

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  Institution Logo                                                                      Power Finance Corporation Ltd.
                                                                                                  (A Govt. of India Undertaking)
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                                       Financial Management of Distribution Management
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   collection [though many SEBs state that they collect ~100+% every year, some of it
   is from outstanding and hence doesn‟t improve its profitability]

   Hence, as a good practice, finance managers prepare a liquidity balance sheet/ cash
   flow to predict the solvency requirements.


              i
           Liqudity Statement for the Month XXX

           Activity                           Book value Realisable
                                                         Value
           Inflows
                  Outstanding Debtors
                  Opening Stock
                  Current Sales
           Total Inflows
           Outflows
                  Purchases
                  Overheads
                  Debt Servicing
           Total Outflow
           Net Cash inflow/ (outflow)
           Cash in Hand/ Bank

           Capital Expenditure Payments
           Cash Shortfall/ Surplus
           Surplus to be reinvested
                   to
           Shortfall be sourced

b. Decision making – accounting purpose is in collection and presentation of data,
   consistently developed and easily interpreted data of the past, present and future
   operations of the company.

   Financial managers use the accounting data for carrying out the following analysis:
         1. Investment analysis
         2. Working capital management
         3. Sources and Uses of funds
         4. Determination of capital structure
         5. Dividend policy
         6. Analysis of risks and returns

c. Valuation principle – accounting records data in the accounting period at its
   historical costs (costs at which the transactions have actually taken place,
   irrespective of movement in the relative purchasing power of rupee) except for
   Inflation accounting & current cost accounting, where financial capital is to be
   maintained at purchasing power terms.



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                                                                                                  (A Govt. of India Undertaking)
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   For inflation accounting, retail price index is considered appropriate. Assets,
   expenses, share capital, reserves and surplus (including depreciation) are indexed,
   whereas income and monetary assets (debtors, cash) and liabilities are not
   converted since they are contracted for a specific value and hence cannot be
   increased with inflation.

   In Current cost accounting the transactions are valued on a „value-to-the business‟
   approach. Adjustments are made for the cost of sales, depreciation, monetary
   working capital adjustments, gearing adjustments (size of debt in the business).

   However, few companies follow such principles and are more of academic research.

   Thus historical accounting fails to add the time-value analysis to its reporting.
   Important function of time value analysis in finance is in forward looking control –
   analysis of options before a resource is committed and understanding the value of
   rupee as it actually received in future period (to re-phrase an old adage: is the rupee
   in hand worth more than one in invested and return it after couple of years?)

3. Time value of money

Value of money received in various time periods – value of money received today is
worth more than the one received later, basically due the reinvestment opportunities
available – varies from firm to firm or individual. Further, inflation erodes the time value
of money received later than now. Thus, the time preference for money is generally
expressed in rate of return or „discount rate‟.

Monies invested earns a „rate of return‟ – if the earning (interest) is returned every
period to the investor without re-investment (day/week/fortnight/month/quarter/half-
year/year), then only the principle earns interest for each period – this is called simple
interest.

If the interest is re-invested i.e. added to the principle, it earns a return now on the
revised principle and hence compounds – this is called compounding interest.

a. Compounding vs Present Value

Compounding means a stream of cash flows not received immediately but appreciation
in value into a future, which can be fixed or flexible. This is called future value (fv) at the
end of period.




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                                                                                                  (A Govt. of India Undertaking)
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Year ended 31/3/          2005      2006      2007      2008       2009     2010     2011      2012      2013     2014     2015    Total

Outflow                 10,000                                                                                                    10,000

Interest rate             10%
Compunding rate                   1.100      1.210   1.331     1.464       1.611    1.772     1.949    2.144     2.358    2.594

Simple Interest Received          1,000      1,000   1,000     1,000       1,000    1,000     1,000    1,000     1,000    1,000   10,000
Compund Interest received         1,000      1,100   1,210     1,331       1,464    1,611     1,772    1,949     2,144    2,358   15,937
Cumulative compund interest                  2,100   3,310     4,641       6,105    7,716     9,487   11,436    13,579   15,937




If we reverse the above, we call it discounting and calculate the present value – single
value or series of cash flows at various periods of time, discounted to their current value
(reverse of future value)
Year ended 31/3/           2005       2006       2007        2008         2009     2010      2011      2012      2013     2014       2015
Calculating Present values
Simple Interest Received             1,000      1,000     1,000      1,000       1,000      1,000     1,000     1,000    1,000     1,000
Compund Interest received            1,000      1,100     1,210      1,331       1,464      1,611     1,772     1,949    2,144     2,358
Case 1

Outflow                  (10,000)
Simple interest flows                1,000      1,000     1,000      1,000       1,000      1,000     1,000     1,000    1,000     1,000

Discounting factor            10%    0.900      0.810     0.729      0.656       0.590      0.531     0.478     0.430    0.387     0.349

Discounted value                      900        810         729          656      590       531       478       430      387         349
Total Present Value       5,862
Case 2
Compounding flows                    1,000      1,100     1,210      1,331       1,464      1,611     1,772     1,949    2,144     2,358

Discounted value                      900        891         882          873      865       856       847       839      830         822
Total Present Value       8,606




b. Differences in rates of interest

Nominal rate is the rate at which an investment is quoted in real time, taking into
account inflation. For eg. 7.5% RBI Bonds means that the coupon rate of 7.5% is in
current inflation rate and this will be paid, irrespective of the inflation rate.
Real rate is inflation adjusted rate. In the above example, if we assume the current
inflation rate is 5%, then the real rate (inflation adjusted rate) will be 2.5%. This is useful
to understand the return that an investment returns.

Floating rate is not a fixed rate but changes according to some base (eg: Bank rate or
PLR – prime lending rate). Fixed rate is fixed for the tenor of investment or loan
irrespective of movements in other parameters, such as inflation or PLR. This is useful
for evaluating situations, where an investor projects the possible movement in interest
rates and evaluates which is the better option. For eg. In a declining interest regime, it
would make least sense to opt for a floating rate of interest instrument.




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Effective rate is the annual percentage rate (APR) applied on diminishing/ increasing
balances of principle Eg. A 7.25% APR on a Home loan of 5 years with monthly rest
works out to 3.9% simple interest over the 5 year period.

Flat rate is the single rate applied on the original principle.

The understanding of rates is useful to calculate and equate various investment
schemes/ borrowings and understand the relative cost-benefits.


c. General uses of NPV, IRR
Year ended 31/3/           2005    2006    2007    2008    2009    2010    2011    2012     2013    2014        2015
Calculating Present values
Simple Interest Received          1,000   1,000   1,000   1,000   1,000   1,000   1,000   1,000    1,000      1,000
Compund Interest received         1,000   1,100   1,210   1,331   1,464   1,611   1,772   1,949    2,144      2,358
Compounding flows                 1,000   1,100   1,210   1,331   1,464   1,611   1,772   1,949    2,144      2,358

Discounted value                   900     891     882     873     865      856     847     839      830         822
Total Present Value      8,606

Net Present Value       (1,394)


IRR
Flows                  (10,000)   1,000   1,100   1,210   1,331   1,464   1,611   1,772   1,949    2,144      2,358

IRR                        8%


Net present value (“NPV”) is the present value of future cash streams over the initial
investment and reflects whether the investment is expected to generate surplus or
shortage.

The important factor which determines the NPV is the discount rate which is used. If it is
higher, then the present value of future flows is lower and vice-versa.
Usually the cost-of-capital to the company (or weighted average cost of capital) is used
as the discounting rate.
Alternately, internal rate of return (“IRR”) calculates that discount rate, which equalises
the present value of future cash flows to that of the original investments.
Usually IRR rate is compared to certain benchmark rate – if it is more than the
benchmark rate, then the investment is worthwhile else not.

IRR is easier to understand than NPV but suffers from multiple rates (due to the use of
higher order polynomial, which can present two solutions to the equation). Further, IRR
also gets skewed with any negative return/ flows/ investments during the project period.

IRR assumes that the future cash flows are invested at the same rate, every time which
is not necessarily true as the surpluses could be used elsewhere within the business.
Any long term projection would suffer from this lacuna and is usually addressed through
sensitivity analysis.

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Before attempt to use this concept, let us also understand another important tool viz
financial analysis.

4. Financial Analysis – what is it?

Financial statements shows overall analysis only – size of revenue, profit/ loss, size of
expenses, size of equity, assets etc. It doesn‟t explain much of relationship between
these figures.

Financial analysis is the analysis of key figures in these statements and the relationship
between them. Ratio analysis is one of the key approaches to financial analysis of
risk/return relationship.

This also helps in inter-company comparison to understand the relative strengths and
weaknesses of the company. Trend analysis, studied over a period to understand the
direction a company is heading.

This tool, along with the understanding of time value helps financial managers in
preparing budgets, monitor them, evaluate benefit-costs analysis and prepare the
business plans for the company.

5. Types of Ratios

Ratios are classified into
a. Liquidity
   Net working capital
   Current ratios, acid test ratio, turnover ratios, defensive-interval ratio, cash flow from
   operations
b. Capital structure/ Leverage
   Debt-equity, debt-assets, equity-assets, interest coverage, debt service coverage,
   dividend coverage, fixed cost coverage, cash flow coverage, operating leverage,
   financial leverage
c. Profitability
   Profit margin, expense ratios
d. Activity/ Efficiency
   Asset efficiency ratio
e. Integrated
   Du Pont analysis
f. Growth
   Internal growth rate, Sustainable growth

Appendix A sets out the various formulae to calculate each type of ratio. Balance sheet
of SPDCL for 2002-03 is attached to this file. As a self-practice, readers are encouraged
to work out he various ratios.

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5.1. Liquidity ratios

Liquidity ratios evaluate the solvency of a firm and capability to meet its current
obligations. Main use is to creditors and lenders (whose annual repayments fall within a
year). Financial manager understands the deployment of resources and whether the
firm is earning right value without excess liquidity (and hence low return?).

Working capital related ratios show whether the firm has invested adequately in running
its business. If there‟s an excess of current assets over current liabilities, then the firm
should look at its investments in current assets.
Is it inventory heavy? There is a possibility of obsolete or non-required stock build up.
Is it possible to liquidate it without heavy costs?

Is it receivables heavy as there is a possibility of non-recovery or over/ disputed billing,
which can lead to short term liquidity crunch?

Is it liability light? Has it exploited the credit period available from creditors properly?

If its current liabilities exceed its current assets, it shows that its creditors are funding its
operations i.e. it is defaulting in payments to creditors may refer to the need for equity
infusion? It may be already facing liquidity crunch and may be at insolvency stage (need
for distress sale of fixed assets?)

Finance manager should prepare a liquidity balance sheet, to understand her cash
flows and plan for raising bridge finance/ long term corrections including equity infusion.

5.2.    Capital Structure/ Leverage

This ratio shows the long term solvency of the company and its capability to service
various providers of capital. Company needs to leverage its capital productivity and
manage its balance between borrowing and equity infusion.

High leverages produce large fluctuations in earnings for equity holders and may also
limit access to debt for expansion. Coverage ratios show the security of payment to
lenders, as to how many times the earnings cover the debt repayment.

For Discoms – consumer security should be calculated as long term debt, since they
are not repayable immediately, though by strict classification they are time-demand
related (immediate settlement, should a consumer leave the grid). However, given the
monopoly of supply, there‟s a remote chance of a domestic consumer leaving a grid and
hence her deposit can be treated as long term. Given the introduction of multiple
licensee approach under the Electricity act 2003, this position may change and this
would be treated as current liability.


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5.3.    Profitability

This set of ratios detail out the profitability margin and cost ratios of operations.
Operating leverage is the ability use fixed costs to magnify the effects of changes in
sales on its earnings before interest and taxes. Also shows the return on investments to
the capital employed/ investment made in the business including earnings per share,
dividend per share, cash per share etc.

5.4.    Efficiency ratios

These ratios show the utilisation of various assets in the business. Quicker the turnover,
the efficient an operation is.

Analysis is required in terms of understanding various causes for lower efficiency.

Eg. analysis of the collection efficiency and whether the company is following the stated
credit policy of the company
   If Domestic consumer receivable turns over 3 times, it shows that the average
   collection period is 1/3 or 4 months, whereas the stated policy of the company could
   be 60 days or 2 months.

5.5.    Du Pont Chart

Integrated approach to the earnings power of the company. This chart shows the
interrelationship between the profitability on sales and assets. Refer to Appendix B.

5.6.    Growth Ratio

Internal growth rate is the rate at which the firm can grow without external financing.
This is due to growth in the assets, net profit margin in proportion to its sales, targeted
dividend payment.

Sustainable growth rate is the maximum the company can grow using internal
resources as well as additional external resources without affecting its financial leverage
– target capital structure to maintain and not considering issue of equity.

6. What is Budgeting?

Budgets are an important profit planning tool. Budget is defined as a „comprehensive
and co-ordinated plan, expressed in financial terms, for operations and investment of an
enterprise for some specified period‟.

Components of budgeting i) Plan ii) detailed activities envisaged iii) co-ordination –
between all the functions of an organisation iv) financial terms v) period


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6.1.    Steps involved in Budgeting

To start with, a „Plan‟ needs to be developed for the business, which then is translated
into strategy, action and implemented. This plan would identify resources required to
implement the actions along with financial implications – revenues to be earned,
expenses, capital to be borrowed or raised.

Budgets are explicit statement of expectations, statement of targets to be achieved,
quantitatively as well as financially. It requires dissemination to all the functions that are
involved. It also introduces framework for monitoring – accounting to support collection,
analysis, summarisation of actual information and comparison with the expected target.
Budgets also provides controls as a part of management control systems– forward
looking, concurrent or feedback systems on the type of solutions used for problem
solving.

7. Types of Budgets

Operating Budgets
       Sales to various categories, power purchase, expenses, repairs and
       maintenance, resource raising – all form part of Annual Revenue Requirement to
       be filed with ERC.
Financial Budgets
       Profit & Loss, Balance sheet, Funds flow statements
Cash Budget
       Cash flows – receipts and expenses under various heads
Capital budgets
       Decision on investment into various areas (network expansion, strengthening,
       system improvement, loss reduction)
Zero based budgeting – zero-based approach to every budgeting period – fresh re-look
at the assumption and questioning the rationale
Rolling budgets – roll-over of planning period (5 years) every year .i.e if a budget is
prepared for 2006-09, then next year, it will be for 2007-10 and so on.

8. Methods of Budgeting

Fixed budgets – sets out a fixed level of activity – most commonly used in SEBs. It
assumes certain level of input, sales etc. easy to comprehend and work out.

Flexible budgets – budget estimates at various levels of activity. Difficult to prepare but
allows organisation to adapt to changing business environment
       Eg: sale of power to agriculture sector vis-à-vis monsoon, hydro availability,
       possible thermal back up, load shedding etc




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                                                                                                  (A Govt. of India Undertaking)
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                                                    Financial Management of Distribution Management
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Every budget should carry out „what-if‟ analysis on its key parameters and also
scenario/ sensitivity analysis to understand the risks involved in estimation i.e. „how
does the budgets change with certain change in assumption of key parameter‟?

Any budget is dependent on the underlying assumptions used for key business
parameters and if these are based on „dirty data‟, then they lead to wasted effect in
budgeting (since the outcome would be much different than what is intended).

Organisations should understand the cost-volume-profit relationship in preparing
operation budgets. Similarly Cost-benefit analysis should be used for capital budgets


8.1.    Zero based budgeting

Basically starts the budgeting with a „de novo‟ approach. Question the rationale for the
expenditure. Evaluates alternative approach possible for each action (whether an
activity should be based in house or outsourced).

 This concept can be used in rolling budgets also. This actually challenges the
organisation into justifying the resource allocation to a specific head and reduces
complacency.

8.2.    Volume-Cost-Profit

VCP analysis shows the relationship between volume, costs (fixed and variable) and
profit – basis for calculating the break-even analysis. Break-even – level of sales at
which the company is able to recover all its fixed costs and the variable cost (upto that
level). Any sales above this would bring profit and below this would bring losses. This
can be graphically shown as
                                                        Breakeven
                                  378
                                  336                                                     e
                                  294                                                 enu
                                  252                                             Rev
                                                                                         costs
                         $(000)




                                  210                                              Total
                                  168
                                  126                                             Fixed costs
                                   84
                                   42
                                    0
                                        0       1000         2000         3000         4000         5000
                                                                   Units
                     ©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster




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Uses

This provides an important analysis in operation budgeting process. Brings about an
understanding of elements of fixed costs, variable and semi variable costs. Allows for
pricing of product for eg. above break-even, products can be priced lower than full costs
and the company will not lose money. Allows management to calculate margin of safety
– focus the revenue enhancing measures or cost-reduction

9. Budgeting Process


                                     Business Plan


                                Annual Requirement

                                                                                       Capital
                                                                                       Expenditure
                        Operations                         Financial
                                                                                       Cash flows

                     Activity/ Function                Project/ Activity



                                     Recording, Analysis


                                       Reporting


10.    Business Requirements

Government requires budgeting process as a part of implementing Financial
Restructuring Plan (“FRP”). FRP is prepared as a part of long term planning by State
Government and hence requires periodic comparisons and mid-course reviews. State
governments also use FRP as a roll-over budget (updating assumptions over a period)

Lenders covenant sometimes requires regular reporting (Eg. World Bank loans).
Regulator may require every licensee to submit budgets, as a part of license
requirement. These form part of its ARR (expected revenue from operations - formats
provided by Regulator) for each and every item of P&L.

Under the multi-year tariff principles, licensees are expected to provide the Regulator
with projections for entire control period (3 or 5 years).



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11.     Techniques to be used in Budgeting

Trend analysis is an extrapolation of future using past as a basis to project the future.
Past data set can be further refined to eliminate known aberrations – Eg. Unusual
natural calamity („tsunami‟ or „rains in mumbai‟).

There can be other methods as „comparable benchmarking‟ – basing the target on how
other similar companies perform in a given situation. This is commonly used in setting
targets such as „Loss reduction‟ where the companies compare the target that can be
achieved.

The third method is called „blue sky‟ approach – developing targets based on clean
slate approach – what can be achieved and should be achieved and will benefit the
company and consumers.

In the following sections, we review the budgeting process for some of the major heads.

12.     Operation Budget

12.1.   Sales

Sales for each and every category in the tariff schedule adopted by the company and
approved by Regulator. Categories consumption projected using various techniques –
trend analysis, scenario analysis, end-use analysis (based on load flow and lead
research methodologies). This is critical, since tariff orders are projected on this basis.
Any mistake would result in lower realisation, which the Regulator may not allow for
adjustment.

In fact anecdotal evidence point to the situation, where higher sale (using aggressive
assumptions have lead to projecting higher revenue and failure of actualising such
revenues, resulted in losses to the companies. For in the alternate scenario, Regulator
would have used lower sales and higher costs and could have allowed tariff increases).

Issues
    Consumption to sales conversion based on commercial loss assumptions for
      various categories
      Tariff orders generally issued on the projections – short fall to the company‟s
      account?
    Excess projection to any single category can distort the cross-subsidy also (eg.
      HT consumption assumed to grow at 11% and cross-subsidy accordingly
      allocated between categories. Now, if HT consumption is less, then there‟s
      double-whammy for the company – loss of revenue, profit as well as cross-
      subsidy)


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       Companies not ready - load analysis and research for which the requisite
        infrastructure is missing by way of load flow meters (demand, energy) on
        feeders, class of consumers and database for a long period to arrive at sensible
        projections. This is one of the major complaint of ERCs – poor quality of data and
        inadequate sample for sensible statistical projections.

12.2. Power Purchase

Till date, Discoms have single supplier viz. Transco. Bulk supplier aggregates the
demand of Discoms (grossed up for losses) and projects total demand – monthly
(followed in certain states only).

Based on the contracts with Central generators, state generator, IPPs and NCEs bulk
supplier calculates the supply availability and calculates the costs associated – fixed
and variable (based on monthly Merit-order, expected quantum of dispatch).

Based on the total supply and costs the average price for each unit of supply is worked
out. Bulk supplier estimates the transmission loss and calculates the delivery cost to
discoms.

Issues
    If demand projections go awry, power purchase cost/ quantum and mix of
      generation (cheap/ costly) is also affected – affects the overall ARR of the entire
      sector – this risk was previously managed by bulk supplier and this may be
      accentuated when the PPAs are vested with Discoms
    Hydro availability is one of the most sensitive areas (large dependence for
      meeting peaking demand) – any changes in the actual dispatches would result in
      the need for costlier fuel adjustment surcharges
    Energy accounting – still being done ex-post at the aggregate state level – needs
      more sophistication and introduction of intra-state ABT (imbalance market and its
      rules)
    Losses – efficiency/ in-efficiencies shared between Utilities and consumers (Draft
      National Tariff policy supposes that power purchase cost should not be
      restrained in any way, with use of normative levels – consumers may protest that
      the Discoms inefficiencies are being passed on without any restraint and no-
      incentive for discoms to be efficient at all)

12.3.   O&M

O & M covers employee costs, administration & General expenses, Repairs &
Maintenance and doesnot cover depreciation, interest and taxes.

Less difficult to project with more stable behaviour of expenses heads. Items can easily
be segregated into fixed and variable. Most of the items can be benchmarked – past


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trend or best company approach. Dis-allowances are also negligible. Area for easy cost-
cutting measures – though overall impact on the tariff could be low.

Issues
    Employee costs – should include adequate provision for all types of costs
      including retirement benefits
    Admin costs – depends on the new office formations/ customer related expenses
    R & M – may require additional evaluation with respect to the state of network,
      legacy of under investments etc
    Proper accounting to be set up – for segregation of liabilities between
      Government and the Disoms (clauses in the transfer scheme – Eg. Pension
      liability for the period upto formation of Discoms – to be borne by Government in
      a specified proportion)

12.4.   Sensitivity analysis

No budget is complete without „fire-testing‟ its assumptions. Such testing shows the
broad-range of values that key parameters can assume. It allows for developing type of
control – forward looking, concurrent and feedback for critical parameters

13.     Multi-Year Tariffs (“MYT”) – Impact on budgets

MYT changes the approach to the fundamental working of the business. Existing „cost
+‟ approach to be replaced by a „performance based‟ approach. Various actions/
functions in the business classified as „controllable/ non-controllable‟. Items/ actions
under this could be – O&M, Losses/ efficiencies, Sales, interest, depreciation, capex

Items/ actions of non-controllable nature – actual merit order dispatch, hydro availability,
force majure such as riot by IP consumers, government policies etc.

AP has issued Long term tariff principles (one of the fore runner of the MYT policy).
Other SERCs have also come out with discussion papers on MYT. NTP also sets up
certain principles for MYT. A detailed note and issues presented in appendix C. refer to
the paper on regulatory process for a detailed discussion in this regard.

14.     Monitoring of budgets

Once budgets have been finalised, then the monitoring process is set in motion. Flexible
budgets would require further dataset to rework the standards based on certain level of
actual activity. This depends on recording, analysis and accumulation of data. This is
compared with the budgets and the variance are analysed as favourable, unfavourable
and causes for variance are analysed and corrective actions, if required proposed.




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15.      Capital budgeting – what’s it?

Capital budgeting – pertains to evaluation of capital expenditure incurrent on assets,
which would involve
      Current or series of cash outlay
      Series of expected returns over periods (relatively large benefits)
      Large risk (due to long period involved)
      Comparison between outlays and inflows
      Decision to incur or delay
      Compliance       to    regulation     –     compulsorily     to     be   incurred
      Eg. Safety procedure for network, system backup to maintain grid frequency
      Enhance      Revenues      –     loss    reduction     to   enhance    profitability
      Eg. Conversion of main trunk routes to higher voltage eg. replacing 400v with
      11kV to eliminate tapping or stringing ABC etc.
      Reduction of costs – introduction of IT systems to enhance accuracy, timeliness
      and monitoring of billing system or introduction of Enterprise wide application
      system etc

15.1.     Process

Process – refers to generating, evaluating, selection and monitoring activities. In capital
budgeting, there are three types of decisions
   a. Accept or Reject – firms would invest in accepted processes only. All proposals
      whose return is above certain benchmark rate is accepted
   b. Mutually exclusive choice – acceptance of one project would automatically reject
      others.
      Eg. If company is planning to invest in network and there are three ways of doing
      it (overhead using conventional conductors, ABC conductors or underground
      cable) with different outlays and operating costs. Selection of one would
      eliminate others. This is used, when more than one proposal meets the above
      „accept-or-reject‟ decision
   c. Capital rationing decision – situations where there are „acceptable‟ investment
      proposals and the company has only certain fixed budget available. It rations this
      amongst the projects with greatest returns.

Estimation of future benefits

      a. Accounting profits – calculates the profit according to the accounting principles
         and hence includes depreciation as a charge
      b. Cash flows – excludes depreciation from calculations and is considered superior
         Initial outlay is cash and future inflows should also be cash.




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Accounting profit doesn‟t recognise this and amortises the cost of investment over its
useful period and hence depreciation is not be considered in capital budgeting.

Secondly cash flow ignores the ambiguities involved in accounting principles for
depreciation, amortisation of expenses etc and hence measures the actual inflows/
outflows                                                                   better.

Thirdly, cash flows take into the „time-value‟ of money and this is ignored in the
accounting treatment.

Finally only relevant cash flows from the project are only to be considered i.e. cash
flows that accrue incrementally due to the capital decision are to be considered.

Cash flows
There are two types of cash flows
Conventional – for an initial outlay this would consists of series of inflows over a period
Non-conventional – initial cash outlay followed by series of inflows interspersed with
outflows.

Treatment of certain items
    Taxes – to be calculated using the tax rules and should also include the benefit
      of depreciation
    Allocation of overheads – methodology to ensure that certain overhead may be
      charged to new project. This should be applied only in the cases, where
      overheads change due to investment in the project
    Working capital effect – if an investment is expected to increase revenue, it may
      also increase debtors, cash and certain liabilities also. The effect of relevant net
      working capital (current assets – liabilities) should also be included
    Replacement situation – in a replacement situation, only the incremental after tax
      cash flows should be considered – For Eg. Replacement of 33 kV substation

15.2. Evaluation techniques
      15.2.1.     Non-time adjusted -1

Average Rate of Return (accounting rate of return) or “ARR” means
      ARR = Average annual profits/ average investment*100
Average annual profits = ∑ annual profit/ years
Average investment = salvage value + ½ (Cost of investment – salvage value)

Accept-Reject rule - uses a predetermined rate and ranking amongst projects that has
passed the accept-reject rule.




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Evaluation
Easy to use – needs accounting profits only, easy to understand but ignores the time
value of money. Doesnot differentiate the size and the risk associated with each
Ignores the benefits that accrue on sale or salvage value of the investment

       15.2.2.       Non-time adjusted -2

Pay back method – number of years for the cash flow after tax to repay the investment,
disregarding the salvage value.
PB = Investment/ constant annual cash flow (in case of annuity) = no of years
PB = Time till when the cumulated cash flows equals the investment (in non-annuity
cases)
Accept-Reject criteria – compare with benchmark period set up for all types of
expenditure.

Evaluation

Easy to calculate and comprehend. Improvement over ARR since the evaluation is
based on cash flows but ignores the cash flows after PB period. Doesn‟t differentiate
timing and size of cash flows

       15.2.3.       Time adjusted

Time adjusted techniques such as the ones presented below follows discounted cash
flow:
      Net Present Value method
      Profitability index
      Internal Rate of Return

General procedure is to compute the time value of cash flows and bring them to their
present value. This is then compared with the investment. This method can be used for
the pay back also and shows an improvement than the earlier one discussed under
15.3.

Net present value

Details the cash flow that occur in the project (include the terminal salvage value also).
Calculate the present value using a discount rate i.e the multiplier to be given to each
year to arrive at their present value.

Net present value = Present value of future cash flows – initial outlay (or present value
of all outlays)

Accept-Reject rule – accept if NPV > 0


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Internal Rate of Return (yield on investment, marginal efficiency of capital, marginal
productivity of capital, time adjusted rate of return)

Defined as that discount rate that equates the aggregate present value of net cash flows
with the aggregate value of net outlays

Accept- Reject Rule: accept IRR above a benchmark rate

Evaluation
Difficult to calculate (unlike NPV) and more so complex for a mixed stream of cash
flows, however, easier to understand – removes the discounting rate bias. IRR focuses
the return that shareholders would expect from investment and hence more appropriate.
However, IRR can produce multiple rates which can be confusing.

Higher IRR may not translate the best proposal – in mutually exclusive proposals, since
it is assumed that all the intermediary cash flows are re-invested at the same rate
(maynt be practical).

Terminal Value method – prepares the present value of cash flows similar to other
methods. However, assumes that intermediate cash flows would be reinvested at
different rates.

Accept-Reject rule – if present value of compounded re-investment inflows is > pv of
outlay – accept

Evaluation
Explicit assumption on re-investment of cash flows can be made and hence easier to
calculate and understand. Major practical problem is in projecting future rate of
investment and these can influence the accept-reject rule.

Profitability Index (“PI”) or Benefit-Cost ratio – similar to NPV method. Only that the
PI measures the index of inflows to outflows i.e. PV per rupee invested
Accept-Reject rule – accept if PI > 1

Evaluation
Indifferent to the size of the investment. Better suited in capital rationing – projects with
better PI will be selected.

Similarities – NPV, IRR
Similarities
Conventional projects – single outflow and steady inflows (NPV and IRR should
produce similar results)
Independent proposals – mutually exclusive proposals will also produce similar results
In most cases, NPV and PI produce similar results


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Differences
In mutually exclusive projects, difference between methods may arise due to
size disparity. This arises due to size difference of investments.

This could be addressed by a) calculating IRR on cash flows and if its > benchmark,
accept project with higher outlay – since company would anyway get return under
smaller project as well as incremental flows return higher than benchmark rates

Time disparity, arises due to timing difference of cash flows. Resolve using - NPV (using
cost of capital as discount rate) would decide the ranking and acceptance

Unequal project lives - arises due to difference in total lives of the projects. Addressed
by common time horizon method – expand the projects to multiple lives to equalise the
time horizon and compare.

Equivalent annual value/ cost – divide the NPV of the cash flows with PV of annuity for
similar life at a given cost of capital – decision criteria is the maximisation of prevent
value or minimisation of cost.

16.    Capital Rationing

Limits the capital available to capital expenditure and hence limit funds available for
investment. No administrative capability to handle larger projects. Conservative and limit
the investment.

Results in less than optimal solution – since firm cannot accept all profitable projects
and may also result in selection of large smaller projects than few large projects,
ignores the cash flows that are generated in the subsequent period.

17.    Cost of capital

Cost of capital is the basis for comparison with the discounted rate in NPV or IRR. This
is defined as the minimum rate of return that the firm must earn on its investment for its
market value to remain unchanged.

Components of cost of capital – specific cost of various type of capital raised by the
company
       Equity, Preference, Convertible bonds, debentures, non-convertible bonds,
       secured term loans, unsecured term loans etc
When the specific component costs are combined, the resultant is the „weighted cost of
capital‟




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Traditional theory

Firm‟s business or financial risk is unaffected by the acceptance or financing of projects
– cost of capital is either increased/ decreased to accommodate risks
Capex determines the business risk (change in EBIT for change in sales), whereas
financing of it determines the financial risk
    k = rj + b + f, where rj represents the cost of particular finance, b the business risk and
f the financing risk

Cost – costs can be
      Explicit – discount rate that equals the present rate of cash inflows that are
      incremental to taking the financing decision with the present value of incremental
      cash outflows

        Implicit - opportunity costs of deploying the funds elsewhere – rate of return
        associated with the best investment opportunity foregone

17.1.   Measurement of specific costs

Cost of debt – coupon rate adjusted for floatation costs (increased for discount,
reduced for premium)
Cost of debt is adjusted for tax breaks available, present value of redemption value
Cost of preference shares – preference dividend + present value of premium
redemption divided by the proceeds

Cost of Equity
Cost of equity – minimum rate of return that must be earned on the equity finance
portion of an investment project that leaves the market value of its equity shares
unchanged.

Dividend valuation model – rate that equals the PV of expected future dividend with the
net proceeds of sale, where D is the dividend, P is the price and g is the growth.
       ke =D1/P0 + g

Capital Asset Pricing Method is a risk-return trade off of investments in the overall
portfolio of investments. Based on the overall efficient market assumption
        Diversifiable/ unsystematic risk – that can be eliminated through diversification –
        hence no concern .
        Non-diversifiable/ systematic risk are factors that affect all the firms.
Cost of equity is measured in relation to the volatility of share (β) to the market (universe
of portfolio or market). β of the share is 1, then the risk of the specified share is equal to
the market.
        ke = rf + β (km – rf)

WACC or Weighted average cost of capital

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       Specific cost of each type of capital (debt, equity)
       After tax treatment of cost of debt
       Multiply the cost of each with the specific weights (usually the composition of
       individual type in the overall capital)

18.    Business Plan

Business plan is that which addresses the positioning of the firm, within an industry,
over a medium term. This plan identifies various factors that affect the business either
internally or externally. It helps in preparing strategies to achieve the plan and in
implementation.

Understanding Business Environment - Internal

Value chain (discussed in detail in sec 12 operations
budget)




                                                                                              High
  Focus on high value, high volatile part of value                                                                                    Power




                                                                       Impact on Financial Health
chain                                                                                                               Losses           purchase
  Many costs are legacy                                                                                          Interest
                                                                                                          Employee
      – more in terms of non-controllable                                                                  Costs
                                                                                                                    R&M
      Eg. PPAs of generators employee costs
             network     condition     and     capital
      structuring Loss component                                       Low
      – ~45% of the value chain Stranded cost?
      – unable to recover costs through tariffs, even                                                       Low                    High
      assuming efficiency levels                                                                     Volatility – changes in projections
Systems – load management, load research

19.    Understanding Business Environment - External

Regulatory (areas to cover would include)
      License conditions                                                           Choice?

      Business reporting
      Choice of accounting policies                              Consumer Power
                                                                                     Relative dominance




      Administration of value chain                           Technology
      Management of capex
      Policies for Performance and return                             Govt Policy
Government
      Policy on retail supply                                              Regulatory Oversee
      Pressure on tariff maintenance
      Policy on cash subsidy support to sector                 Business Impact
      Micro management and controlled organisation
      Administration approach rather than commercial approach



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Consumer power
     Limited understanding of the operations
     Administered prices – shelter against economic costs
     Incentive to under report/ appropriate economic costs
     Threat of open access – choice finally!

20.    What do they mean in Business Planning?

Will the business model change in next few years? – Yes. Companies need to focus on
not only supply excellence (few breakdowns, more quality power to all categories) but
also customer retention.

Key drivers
    a. power      procurement       (increased   cost,
       payments for reserves to correct voltage
       and frequency,          spot    payments    for
       imbalances)
    b. higher investment in infrastructure – better
       metering and energy accounting systems,
       load research and management
    c. changing industry structure – more
       competition at bulk market to procure,
       customer attrition (loss of beneficial cross-
       subsidy – financially and technically), more
       transparent accounting of transfer prices
       between G to D
    d. Large legacy issues unaddressed – PPAs
       with restrictions and long life, continuance of
       state genco as banker, higher payment
       security to all players
    e. Markets – higher regulatory compliance
       costs, especially in MYT (complex
       accounting and reporting of factors and
       causes), large initial filings and public
       discussions
Data set – poor quality to defy any scientific approach to forecast and management and
business plans end up as theoretical exercise – high subjective judgements with less
rigour possible.

Subsequent sections explain the various components required in developing a business
plan.




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21.      Strategic Planning - explained

Mission statement – a broad yet clear and concise statement as to what the
organisation does. This provides the direction that a company should take.

SWOT – Strengths, Weaknesses, Opportunities, Threat analysis
SWOT helps in conducting „Gap analysis‟ and can be useful to benchmark the
organisation in the sector, industry
It is a crucial tool and depends on the rigour that is bought into shaping the plan for the
organisation.

Goal setting – desired end result or target
Develop Operational and tactical strategies – implementation plan to achieve goals.

Monitoring – continuous evaluation of plans

      21.1.     Mission, Vision statements

Successful organizations continually innovate and change based upon customer needs
and feedback.
Values, mission, and vision form the foundation for the execution of the functions of
management.
They are an organization's guidelines that affect how it will operate.
They work only if visible and used in everyday activities and decisions. An
organization's values are its beliefs or those qualities that have intrinsic worth and will
not be compromised. Its mission is its purpose for existing. The vision is the image of
itself in the future.

Values - Base line for actions and decision making. Guides the employees towards
organisation‟s intentions and interests

Mission -Clear purpose of the Organisation. It provides its employees with shared sense
of opportunity, direction and significance. It allows employees to work independently but
collectively towards realising the Organisation‟s goals. Should be easily recallable and
provide motivation to its employees

Vision is „the best way to predict your future is to create it‟ as defined by Eric Fromm.
Vision describes the preferred future, ability to visualise changes and drive towards
achieving the same.
Eg. functional unbundling of the sector to introduce efficiencies in functions – a Chilean
foresight.

These two drive the approach to every planning document that the companies produce


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   21.2.      SWOT Analysis
Analysis of Strengths, Weaknesses, Opportunities and Threats
Strengths
      Operational – clean data, efficient network, excellent up-time, least technical
      losses, highest quality of power supplied, best technology deployed etc.
      Financial – capital structure, cost of financing, access to low cost resources
      (suppliers, lenders, public), market rating and standing
      Organisational – employee productivity, organisation structure, ethical values,
      customer-interface, regulatory interface
Weaknesses
      Similar to strengths but operate the opposite way. Identified by the company
      through introspection at areas that it is not strong vis-à-vis competitor.
Opportunities
      Changing industry structure – areas that the company can move in and gain
      competitive advantage
      Areas in which competitors are weak and which can be exploited by the company
      Emerging technologies, trends that can be best leveraged by the company
Threats
      Flanks left open – that can be exploited by competitors
      Changing industry structure which provides competitor with advantage
      Regulatory practice that can constrain the company from making super profits

Benchmarks help in understanding relative positioning within the industry. Best
practices would encourage „truly world class‟ approach by the companies
This would provide a „gap‟ in the organisation capabilities and hence a meaningful
setting for strategic planning. Goals would be better defined and aligned.

   21.3.        Developing Goals & Objectives

Gap analysis identifies the Goals and objectives that would align the company with its
mission and vision and forms the basis for preparing action plans. Companies would
have long term goals such as RoI, EPS, Market share etc.

Developing Goals & Objectives

Objectives – object or aim of an action - converts mission and gaps into specific
policies, programs and operations. Provides input for preparing strategic and tactical
plans based on strategic plan. It also provides specific ideas, focus plans for achieving
the strategic plan. Time frame can be a year or less and it sets out in detail as to who
will do, what, when and how.

The Operational plan based on tactical plan and helps in converting tactical plan into
day-to-day operations.



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Policies are defined as specific directions given but not how to do it. Procedures set out
the detailed step by step process to implement policy. Methods define the way of doing
repetitive tasks and rules define permissible behaviour.

Elaborate data accumulation, analysis and monitoring systems would be required to
ensure that the desired results are produced.

Setting Objectives
Guidelines for setting objectives, use the mnemonic SMART
       S – specific. Every objective should have single key result
       M – measurable. Avoid infinitives like to understand, to know etc. However
       difficult it might be, its better to have metrics for measuring the key result
       A – attainable. Must be attainable with right resources in right time. Challenges
       can be introduced by stretching the targets, but they should be still attainable –
       zero transformer failure rate within the constraints of pre-defined inventory and
       R&M budget
       R – result-oriented should be central to the organisation‟s goals. Successful
       achievement of objective should make a difference to the organisation
       T – time limit. Set time limit and must be possible to do it in that time.

22.    Conclusion

The above tools and understanding of the time value would be necessary for efficient
functioning of finance manager. It is suggested that finance managers also go through
the companion paper in this series which explain accounting, cost accounting and
regulatory framework, so that all aspects of the business is understood in detail.




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Appendix A

Formula for calculating various ratios

1) Debt to Total capital Ratio              = Long – term debt
                                               permanent capital


2) Debt to total assets/capital ratio             = Total debts
                                                     Total assets


3) proprietary ratio             = Proprietor‟s funds X 100
                                    Total assets


4) Interest coverage ratio        = EBIT _______
                                    Interest


5) Dividend coverage ratio              = EAT__________
                                          Preference dividend

(EAT = Earnings After taxes)

6) Total fixed charge coverage Ratio               = EBIT + Lease payment_____________
                                                    Interest + Lease payments (preference
dividend
                                                          +Instalment of principal / (1-t)

                              = EBIT + Lease payments + Depreciation +
7) Total Cashflow Coverage Ratio
                                 Non-                                     cash
expenses__________________________
                                 Lease payment + Interest +(Principal repay
                                                                (1-t)
                                 -ment) + (Preference dividend)
                                           (1-t)

                                        n
8) Debt- service coverage Ratio(DSCR) =  EAT t + Interest t + Depreciation t+OAt
                                         t=1 _______________________________
                                         n
                                              Instalment t
                                         t=1


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9) Profitability Ratios Related to sales

Gross profit margin      = Gross profit X 100
                           Sales

10) Net profit Margin

 i) Operating profit ratio     = Earnings before interest and taxes (EBIT)
                                  Net sales


ii) Pre-tax profit ratio = Earnings before taxes (EBIT)
                                Net sales

iii) Net profit ratio = Earnings after interest and taxes (EAT)
                                    Net sales


11) Expenses Ratio

i) Cost of goods sold ratio                   = Cost of goods sold X 100
                                                    Net sales

2. Operating expenses ratio               = Administration expenses + selling expenses X 100
                                                         Net sales

3. Administrative expenses ratio = Administration expenses                          X 100
                                       Net sales

4. Selling expenses ratio                = Selling expenses X 100
                                               Net sales

5. Operating ratio           = Cost of goods sold + Operating expenses X 100
                                             Net sales

6. Financial expenses ratio = Financial expenses X 100
                                 Net sales


12) Return on assets (ROA)               = Net profit after taxes X 100
                                           Average total assets

    ii)ROA            = Net profit after taxes + Interest X 100
                           Average total assets

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   iii) ROA     = Net profit after taxes + Interest X 100
                       Average tangible assets

  iv) ROA       =Net profit taxes + Interest X 100
                   Average fixed assets

      ROA= EAT+(Interest – Tax advantage on interest ) or After tax interest cost
            Average total assets / Tangible assets / Fixed assets


13) Return on capital employed (ROCE)

1. ROCE = EBIT                                               X100
           Average total capital employed


2. ROCE = Net profit after taxes + Interest – Tax advantage on interest                             X100
                          Average total capital employed


3. ROCE = Net profit after taxes + Interest – Tax advantage on interest X100
          Average total capital employed – Average intangible assets

14. Return on total share holders equity = Net profit after taxes__________ X 100
                                           Average total shareholders‟ equity


15. Return on ordinary shareholders Equity (Net worth)

Return on equity funds          = Net profit after taxes - Preference dividend_____ X100
                                  Average ordinary shareholders equity or net worth

16. Earnings per share (EPS)

EPS = Net profit available to equity – holders
      Number of ordinary shares outstanding

17. Cash earning per share = Net profit available to equity – owners + Depreciation +
                            Amortisation + Non-cash expenses_________________
                              Number of equity shares outstanding

18. Book value per share = Net worth ___________________________________
                           Number of equity shares outstanding


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19. Price to Book value Ratio = MPS
                                BPS

20. Dividend per share (DPS) = Dividend paid to ordinary share holders
                               Number of ordinary shares outstanding


21. Dividend pay-out ratio = Total dividend (cash dividend ) to equity holders X100
                              Total net profit belonging to equity holders

 ii) D/P ratio = Dividend per ordinary share (DPS) X 100
                 Earning per share (EPS)


23. Earnings and Dividend yield
                     EPS_______________                   X 100
1) Earning yield =   Market value per share


2) Dividend yield = DPS____________________ X 100
                     Market value per share

24. Price earnings (P/E) Ratio = Market price of share
                                 EPS


25. Inventory turnover Ratio = Cost of goods sold
                                Average inventory

26. Inventory turnover Ratio = Sales________________
                               Closing inventory

27. Raw material turnover Ratio      = Cost of raw materials used____
                                       Average raw material inventory


28. Work – in – Progress turnover Ratio = Cost of goods manufactured
                                          Average work- in – progress inventory


29. Debtor turnover Ratio = Credit sales _________________
                            Average debtors + Average bills receivable (B/R)



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30. Debtor turnover = Total sales _______________
                       Debtors + Bills receivable

31. Average collection period = Months (days) in a year
                                 Debtors turnover

32. Alternatively = Months (days) in a year (X) Average Debtors + Average B/R
                      Total credit sales

33.Assets Turnover Ratio

1. Total assets turnover    = Cost of goods sold
                             Average total assets

2. Fixed assets turnover = Cost of goods sold
                           Average fixed assets

3. Capital turnover        = Cost of goods sold
                              Average capital employed

4. Current assets turnover = Cost of goods sold
                            Average current assets

5. Working capital turnover ratio = Cost of goods sold
                                     Net working capital


34.Integrated Analysis of Ratios

i) Earning power = Net profit margin X Assets turnover

ii) Earning power = Earning after taxes X Sales       = EAT____
                        Sales              Total assets  Total assets


34.Internal Growth Rate (IGR) = ROA X b
                                1-(ROAXb)

Note: b is retention ratio ( 1- Dividend payout ratio)

35. Sustainable Growth Rate (SGR) = ROE X b
                                    1-(ROEXb)

SGR = PX AX A/EXb
     1-(PXAXA/Exb)

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36.Current ratio                         = Current assets____
                                           Current liabilities

37. Acid- test/Quick ratio               = Quick assets_____
                                           Current liabilities

38. Inventory Turnover ratio             = Cost of goods sold___
                                           Average inventory

39. Debtors turnover ratio              = Net credit sales_____
                                          Average debtors

40. Creditors turnover ratio            = Net credit purchases___
                                          Average creditors

41. Defensive – interval ratio          = Liquid assets________________
                                          Projected daily cash requirement

42.Projected daily cash requirement = Projected cash operating expenditure
                                      Number of days in a year (365)

43. Cash- flow from operations ratio = Cash flow from operations
                                       Current liabilities

44. Debt-Equity Ratios                   = Long-term debt_______
                                           Shareholders‟ equity

  ii) Debt-Equity Ratios                 = Total debt______
                                           Shareholder‟s equity


45. Debt/equity ratios                   = Total debt (long term debt +current liabilities)
                                           Shareholders funds

46. Capital gearing ratio = (preference share capital + Debentures + Other borrowed funds)
                             Equity funds (net worth)




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Appendix B

Du-Pont Analysis showing the multiple layer analysis.

  Net Sales
    70.1



   Cost of
 goods sold
    55.2              Profit after
                         tax
                          3.4

 Operating                                        Net Profit
 Expenses                                          Margin
    6.0                   .                        4.85 %
                          .


                        Sales
  Interest              70.1
     2.1

                                                                          Return on
                                                    X
                                                                            Total
                                                                           assets
     Tax                                                                   7.18%
     3.4



                          Sales
 Net Current              70.1                      Total                                            Return on
   Assets                                          Assets                                             Equity
     12.9                                         Turnover                    X                       13.0 %
                              .                      1.48
       +                      .

   Fixed
                         Total
   Asset                                             Total
                         Assets
    33.0                                            Assets
                          47.4
                                                     47.4
                                                                          Financial
   +                                                  .                   Leverage
                                                      .                      1.81
   Other
                                                   Net Worth
   Assets
                                                     26.2
    1.50




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Appendix C
Lists out some of the important points for discussion on the Draft National Tariff Policy
 Sl.   Issue           Clause Clauses in the draft National Tariff Policy

 1     GENERAL         5.3 (a)    Central Commission to notify rate of return on equity for
       APPROACH                   generation and transmission projects (ROR notified by
       TO TARIFF                  CERC for transmission to be adopted by SERCs for
                                  distribution)

                       5.3 (b)    Debt -Equity ratio norm of 70:30 to be adopted ; excess to
                                  be treated as loans at weighted average ROI

                       5.3 (c)    Depreciation in respect of generation and transmission
                                  assets; same applicable for distribution

                       5.3 (d)    Cost of debt ( interest rate), as per agreement with
                                  lenders, to be re-fixed after every three years; CERC to
                                  determine ceiling on allowable interest rates

                       5.3 (f)    The Operating parameters in tariffs should be at
                                  “normative levels” only and not at “lower of normative and
                       5.3 (f)
                                  actuals”.
                                  The Central Commission to notify operating norms from
                                  time to time for generation and transmission. That for
                                  distribution networks to be notified by concerned SERCs.

                       5.3 (h) Multi Year Tariff framework to be adopted from April 1,
                       1       2006 and have a five-year control period (initially 3 year
                               duration)

                       5.3 (h) Where operations are much below the norms for many
                       2       previous years, the initial starting points for determining
                               revenue allowance and improvement trajectories to be at
                               “actual” levels and not “desired” levels.           Suitable
                               benchmarking studies to be conducted to establish the
                               “desired” performance standards. Separate studies
                               required for each utility to assess capital expenditure.

                       5.3 (h) Uncontrollable costs to be recovered within the financial
                       3       year itself ( typically on a quarterly basis)

                       5.3 (h) Accounting separation between distribution and supply to
                       4       be undertaken by utilities



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Sl.   Issue          Clause Clauses in the draft National Tariff Policy

2     GENERATION 6.2 (1)        Availability Based tariff (ABT) at State level to be
                                introduced by April 2006.
                                Central Commission to introduce differential rates of fixed
                                charges for peak and off peak hours.

                     6.2 (2)    Adequate payment security arrangements to the
                                Generating companies need to be ensured (like letter of
                                credit, escrow of cash flows).
                                In case of default despite security, Gencos to be allowed
                                to sell to other buyers without losing their claim on
                                committed capacity charges in case of under-recovery of
                                those charges from the alternate sales made.

                     6.2.15     Liquid fuels can be an alternate fuel in generating stations
                                for emergency purposes and for other specific needs.
                                Such plants can also meet the requirement of
                                decentralized distributed generation for remote locations.

                     6.2.20     One of the major achievements of the power sector has
                                been a significant increase in availability and plant load
                                factor of thermal power stations especially over the last
3.    GENERATION                few years. Renovation and modernization, with financial
      (cont‟d)                  support of Government of India, for achieving higher
                                efficiency levels needs to be pursued vigorously and all
                                existing generation capacity should be brought to
                                minimum acceptable standards. Full compliance with
                                prescribed environmental norms and standards must be
                                achieved.

4     TRANSMISSION   7.1 (2)    The National Electricity Policy mandates that tariff be
                                sensitive to distance, direction and related to quantum of
                                power flow. Same to be developed by CERC on the
                                advice of CEA to be implemented by April 1, 2006.

                     7.1 (4)    As per NEP‟s approach, CTU/STU to undertake network
                                expansion, on identifying requirements from stakeholders
                                and execution after due regulatory approvals.

                     7.1 (7)    To meet revenue requirement of transmission developers
                                (other than CTU/STU) competitively determined annuity
                                may be added to revenue pool, to be recovered through
                                transmission tariffs.

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Sl.   Issue         Clause Clauses in the draft National Tariff Policy

                    7.2 (1)       Transactions to be charged on basis of average losses on
                                  the transmission system.

                    7.2 (2)       Commission may require necessary studies to establish
                                  the allowable level of system losses.

5     DISTRIBUTION 8.1 (1)        Implementation of MYT to restrict tariff adjustments to the
                                  level of power purchase prices and inflation indices.
                                  Applicable to both public and private utilities.

                    8.1(2)         The State Commission to introduce mechanisms for
                                  sharing excess profits and losses with consumers.
                                  In the first control period, incentives may be asymmetric
                                  – excess profits may be at higher levels than losses to be
                                  borne by the utility, yet necessary.

5     DISTRIBUTION 8.1 (4)        Licensees may charge tariffs lower than that approved by
      (cont‟d)                    State Commission

                    8.1 (5)       Initially a large uncovered gap may exist                                      between
                                  required tariffs and that presently applicable.
                                  As far as possible the gap should be met through tariff
                                  charges alternative means that could inter-alia include
                                  financial restructuring and transition financing.

                    8.1 (8)       Appropriate commissions may initiate tariff determination
                                  and open corresponding regulatory scrutiny on a suo
                                  moto basis in case the licensee does not initiate filings
                                  timely.

      DISTRIBUTION 8.2.1          All power purchase costs need to be considered
      (cont‟d)      (1)           legitimate unless it is established that the merit order
5
                                  principle is violated or power has been purchased at
                    8.2.1
                                  unreasonable rates.
                    (1)
                    (cont‟d) Power purchase costs not to be linked with normative
                             T&D loss.
                                  NEP holds that consumers ready to pay tariffs, which
                                  reflect efficient costs, have right to 24-hour power supply.

                    8.2.1         ATC loss reduction can be incentivised by linking returns
                    (2)           in a MYT framework to an achievable trajectory.

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Sl.   Issue         Clause Clauses in the draft National Tariff Policy
                                  Third party verification of energy audit results for different
                                  areas/ localities could be used to impose area/ locality
                                  specific surcharge for greater ATC loss levels and this in
                                  turn could generate local consensus for effective action
                                  for better governance.

                    8.2.1         Any uncovered gap on account of unpaid but due subsidy
                    (3)           remaining at the end of the year would be added in the
                                  annual revenue requirement of next year for the purpose
                                  of tariff determination.

                    8.2.1         Utilities should be allowed to provide for opening
                    (4)           balances of receivables as per policies developed by the
                                  Board of Directors and subject to the approval of the Sate
                                  Commision.

5     DISTRIBUTION 8.2.1          During the transition period controllable factors should be
      (cont‟d)      (5)           to the account of utilities and consumers in proportions
                                  determined under the MYT framework.

                    8.2.2         The facility of a regulatory asset ( to limit tariff impact in a
                    (c)           particular year) adopted by Regulatory Commissions to
                                  be done as an exception. Recovery of Regulatory Asset
                                  should not exceed a period of three years and within
                                  control period.

                    8.2.2         Facility of Regulatory Asset not to be repetitively used.
                    (d)

                    8.3           Section 61 (g) states that Appropriate Commission shall
                                  be guided by the objective, tariff progressively reflects the
                                  cost of supply of electricity.

                    8.3 (1)       Tariffs for designated groups ( say those below poverty
                                  line) to be atleast 50% of the average cost of supply.

                    8.3 (2)       SERC to notify roadmap by September 2005 so that by
                                  end of 2010-11, tariffs to be within  20% of the average
                                  cost to serve.

5     DISTRIBUTION 8.3 (3)        Tariff for agricultural use may be set at different levels for
      (cont‟d)                    different parts of a state depending on the condition of the
                                  ground water table.

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Sl.   Issue         Clause Clauses in the draft National Tariff Policy

                    8.3 (5)    Metering of agricultural / rural consumers can be
                               achieved in a consumer friendly manner through
                               panchayat institutions, user associations, co-operative
                               societies, franchises etc as provided in section 5 of the
                               Act.

                    8.4 (2)    NEP states that existing PPAs with the generating
                               companies need be suitably assigned to distribution
                               companies.
                               The resultant bulk supply tariff and relative performances
                               of licensees to be considered in determination of retail
                               tariff rates notwithstanding likely non-uniform tariffs
                               across a State.

5     DISTRIBUTION 8.5 (1)     The Policy states that the additional surcharge on
      (cont‟d)                 consumers permitted open access should not be so
                    8.5 (1)
                               onerous that it eliminates competition.
                    (cont‟d
                               The basis for computing cross-subsidy surcharge would
                    )
                               be the excess of the actual tariffs applicable over the
                               weighted average of power purchase costs of top 10%
                               power excluding the procurement from liquid fuel based
                               sources.

                    8.5 (4)    The fixed charges for obligation to supply as per section
                               42 (4) of the Act to be applicable only if power purchase
                               commitments has been and continues to be stranded.
                               The fixed costs related to network assets would be
                               recovered through wheeling charges.

                    8.6(1)     Standby arrangements should be provided by the
                               licensee, on payment of tariff of that consumer category
                               or applicable UI charges whichever is higher.




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Common Abbreviations

APDRP – Accelerated Power Development and Reform Programme
ARR – Annual Revenue Requirement
AS – Accounting Standard
BS – Balance sheet
CARO – Companies (Auditor Report) Order
CERC – Central Electricity Regulatory Commission
Companies Act – The Companies Act, 1956, as amended from time to time
CWIP – Capital Work-in-Progress
E(S) Act – Electricity (Supply) Act, 1948
EA 03 – Electricity Act 2003
EMD – Earnest Money Deposit
ERC – Electricity Regulatory Commission
ESAAR – Electricity Annual Accounts Rules, 1985 Rules, 1985
FIFO – First in and First Out
GAAP – Generally Accepted Accounting practice
IT – Income Tax
MACARO – Manufacturing and Companies (Auditor Report) Order
MIS – Managerial Information System
MMD – Months of Minimum Demand
MYT – Multi-year Tariffs
NEP – National Electricity Plan
NHPC – National Hydro Power Corporation Ltd
NPC – Nuclear Power Corporation
NTP – National Tariff Policy
NTPC – National Thermal Power Corporation Ltd
PGCIL – Power Grid Corporation of India Limited
P/L, P&L – Profit and Loss account
PF – Provident fund
PPA – Power Purchase Agreement
SEB – State Electricity Board
SERC – State Electricity Regulatory Commission




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