CHAPTER 7 A SUMMARY OF FINDINGS, CONCLUSIONS AND SUGGESTIONS. Financial management is primarily concerned with the optimal use

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1 CHAPTER 7 A SUMMARY OF FINDINGS, CONCLUSIONS AND SUGGESTIONS Introduction Financial management is primarily concerned with the optimal use of finance - the most notable scarce resource in modern societies. Financial management decisions can be grouped into four broad categories namely, investment decision, capital structure decision, working capital decision and dividend policy decision. All these decisions aim at maximizing the return and minimizing the risk. To ensure this, each of the above decisions is related to the objectives of financial management, viz., maximization of the wealth of the owners in private sector corporate enterprises. A cooperative society is a unique form of business organization. It fundamentally differs from a private corporate enterprise. The latter's wealth maximization objective is not relevant to a cooperative society. A cooperative is a service-oriented organization. Its primary objective is to render service to its members at the minimum cost. This can be achieved by minimizing the cost of administration which includes cost of capital. The objective of financial management in cooperatives, therefore, is to bring down the cost of capital.

2 269 Financial management decision in cooperatives should aim at reducing the cost of capital. Capital structure decision is thus a significant decision. In a private enterprise, increasing the proportion of debt - otherwise known as financial leverage - helps in bringing down the overall cost of capital because debt is the cheapest source of finance. Various theories on capital structure decision support this fct. But in a cooperative, equity is considered as the cheaper source of finance because equity in cooperatives command only a limited interest and they are not traded in stock exchanges and further they are not considered as a form of investment. Leverage or increase in the proportion of debt in the capital structure would increase the cost of capital and thus leverage is detrimental to cooperatives. The present study principally aims at testing the nature of relationship between capital structure and cost of capital and the factors which influence this relationship. The study is confined to all the cooperative sugar and spinning mills in Tamil Nadu, which commenced production prior to 1983-'8f. Findings A Review of Working of Sample Cooperative Sugar and Spinning Mills Tamil Nadu ranks third in the country in terms of sugar output as well as sugarcane production. There are 25 sugar mills in Tamil Nadu of which 12 are in cooperative sector, 9 in private sector and the rest in public sector.

3 270 The cooperative spinning mills were organised in early 50's. Tamil Nadu was the first to start spinning mills in cooperative sector and each district has a cooperative spinning mill. Objective : The objective of the cooperative sugar mills is to manufacture sugar and its by-products to the best advantage of members, whereas the objective of cooperative spinning mills is to promote the interests of weavers and growers of cotton and to industrialise the backward regions. Age of the Mill : Around 70 percent of the cooperative sugar mills are of long standing ones. Around two-third of cooperative spinning mills fall under the age group of years. The average age was around 20. Membership : The membership of the cooperative sugar mills is composed of sugrcane growers, cooperative institutions and government. The membership registered a spectacular growth recording eighteen-fold increase over a period of 23 years. The average rate of annual growth for the industry as a whole was percent. Such a sharp increase in membership was maianly due to the establishment of new sugar mills in the cooperative sector, expansion of the exisitng mills, membership drive to meet the increasing demand for sugarcane and the growers' desire to find a better market for their cane. The membership of the cooperative spinning mills which primarily consists of primary weavers cooperative societies, cotton growers, handloom

4 "I -T t weavers and cooperative institutions had registered a six-fold increase over the study period. But the rate of growth was slow especially between 1963-'64 and 1968-'69. Funds : The major sources of long-term funds for both the types of mills are term lending institutions, State Cooperative Bank and National Cooperative Development Corporation and the State Government. The working capital is raised through cash credit accommodation from Central Cooperative Banks and Commercial Banks and 'ways and means' advance from the State Government. Management : The bye-laws of the cooperative sugar mills provide for the constitution of board of management consisting of 15 members. Sixty percent of them are nominated representatives of external organizations. Elected representatives constitute only 40 percent in the board of management. Even this has not been given a proper trial. The committees of management of the mills were superseded in Since then they were managed by special officiers. The cooperative spinning mills were managed by the democratically elected board of management till August, Since then the boards were reconstituted thrice and they consist of officials only. Organizational Structure : The organizational structure is almost the same in all the cooperative sugar and spinning mills. It remains without much change over a period despite their growth and development. There was no finance department in both the types of mills. The accounts

5 272 department looks after routine finance functions and the mills have not given due attention to finance management proper. The authority is highly centralised in cooperative spinning mills than in sugar mills. Production : The growth of the sugar mills largely depends upon the price of the input and output. This can neither be manipulated nor controlled as it is fully influenced by the government policy. However factors like installed capacity, capacity utilization, manufacturing cost, and recovery can easily be manipulated to the best advantage of the mills. All the sugar mills are now operating with a crushing capacity of 1250 TCD or above, the average being 1695 TCD. The average capacity utilization of the mills widely fluctuates. It was as high as 110 percent in 1964-'65 and as low as percent in 1980-'81. The average capacity utilization was lower than All-India average. On an average each sugar mill has to crush cane for 172 days in a season to achieve 100 percent utilization. The average number of cane-crushed days was 214 in 1964-'65. at 120 days in 1983-'84. This has steadily declined over a period and stood Many of the mills, especially in the latter part of the period under review, could not crush cane even for the minimum number of days. The major reasons for the fall in the number of days cane crushed are fall in sugarcane production and diversion of registered cane to the manufacture of gur and khandasari.

6 273 Recovery is a measure of technical performance of the sugar industry. A sugar recovery of 8.5 percent is considered satisfactory. All the mills have exceeded the minimum of 8.5 percent. The average recovery has risen from 8.42 percent to 9.64 percent over a period of time. The rise in recovery is attributed to cane development activities undertaken by the mills. Another measure of technical efficiency is the rate of extraction of sucrose from the cane. The extraction rate has consistently exceeded the norm of percent and was; higher than the All India average. The total production of sugar by the mills has increased from 2.74 lakh quintals in 1961-'62 to lakh quintals in 1983-'84 ; whereas tine average production per mill recorded fluctuations. In the case of cooperative spinning mills, a minimum installed capacity of 25,000 spindles is essential for a mill to operate as an economically viable unit. Most of the mills at the time of their establishment did not have this minimum capacity. Subsequently the capacity of the mills was expanded and now all the mills have the capacity to operate as economically viable units. Majority of the cooperative spinning mills recorded poor utilization of the capacity with less than 85 percent of the installed capacity upto In the subsequent years the situation improved a lot and many mills were found to have achieved the norm of 95 percent. This was mainly due to revised standards of working hours and days. The major reasons for the under-unitization of the capacity were power shortage and shortage of skilled labourers.

7 27* The average production of yarn per spinning milh has increased from 6.56 lakh kgs of yarn in 1961-'62 to lakh kgs of yarn in 198*. The expansion of the capacity, higher capacity utilization especially in the latter part of the period under review and modernization of plant were responsible for the increase in production. Cost of Production : The average cost of production in the cooperative sugar mills has increased from Rs to per quintal - nearly five-fold increase over a period of 20 years. The rise in cost of production is witnessed in all the mills under study. An analysis of the cost of production of sugar shows that the cost of raw material consituted 60 to 70 percent and interest on borrowings 3 to 10 percent of the total cost of production. In the case of cooperative spinning mills, count-wise costing provides a base for deciding appropriate product mix. Unfortunately, mills in cooperative sector have not given due attention to this. The conversion of production figures to yarn of 40's shows that the cost of production per kg of yarn has increased from Rs.7.42 in 1968-'69 to Rs in registering more than four-fold increase. The break-up of the cost of production reveals that raw material alone accounted on an average for about 62 percent of the yarn selling price. The proportion of salary and wages ranged between percent and percent. Sales : The sale of sugar is influenced by government's policy and control over sugar. The Government has adopted a dual pricing policy underwhich 65 percent of the output is acquired at a fixed low price by the

8 275 government for the public distribution system and the remaining output is allowed to be sold in the open market. The average selling price of sugar has increased from Rs.l per quintal in 1961-'62 to Rs in 1980-'81 - recording a three-fold increase. This is lower than the average cost of production. In some mills the cost of production has exceeded the selling price. This has resulted in losses. The price of yarn in cooperative spinning mills is fixed by the yarn price sub committee constituted by the government. Yarn is mainly sold to the weavers' cooperative societies. Surplus, if any, is sold in the open market through brokers. Selling prices were invariably fixed below the cost. The periodical revision in selling rates was not commensurate with the increase in the various items of overhead. The value of yarn marketed by the mills recorded an impressive growth. The average annual growth ranged between Rs.0.67 crores to Rs.2 crores. Financial Performance : The profitability of an enterprise depends among other things on the effective utilization of resources. The utilization of resources was measured through total assets turnover, fixed assets turnover, inventory turnover and net working capital turnover ratios. The first three turnover ratios in the case of cooperative sugar mills were below the standard norms, which indicate ineffective utilization of total assets, fixed assets and inventory. The net working capital turnover of the sugar mills was more than the standard norm and thus it could be said that the mills were efficient in utilizing the short-term funds.

9 276 The average total assets turnover for the cooperative spinning mills had increased from 0.52 to 1.19 over the years. The average fixed assets turnover had increased from 1.24 in 1964-'65 to k.\7 in 1984, but it was well below the norm throughout the period under review. The inventory and the working capital turnovers of the spinning mills were on the higher side. The gross profit of the cooperative sugar mills registered an upward trend. The net profit was low except in 1980-'81 and 1983-'84. Gross operating margin was less than the norm of 30. fairly good in many of the years under review. Net operating margin was Sales margin and return on investment were poor except in 1980-'81 and 1983-'8'f. By and large the rate of profitability of the mills was found to be unsatisfactory. The average gross profit of the cooperative spinning mills ranged from 3.07 lakhs to Rs lakhs. Since 1964-'65 many mills suffered losses. The rate of profitability of the spinning mills in terms of gross operating margin, net operating margin, sales margin and return on investment was far from satisfactory. The liquidity of the mills was measured through current and quick ratios. The current ratio of the cooperative sugar mills came down from W5 percent in 1961-'62 to 109 in 1980-'81. The quick ratio was less than 50 percent in many years indicating poor liquidity of the cooperative sugar mills.

10 277 The current ratio of the cooperative spinning mills was found to be good whereas the quick ratio of 75 percent of the mills was less than 100 percent which indicates their poor liquidity position. Sickness in Cooperative Spinning Mills : The South India Textile Research Association's norm for measuring the sickness in spinning industry was applied in the study. The results show that the mills had vast scope for improving their profit and profitability. There is no chance for any mill to become sick. Financial Management : Analysis of financial management practices is not the objective of this study. Yet, the researcher could identify certain lacunae in the financial management practices of the mills. Personal observation also helped him to understand certain pitfalls. They are stated below. Capital budgeting system is in vogue in both the categories of mills. But investment proposals are evaluated only on the basis of traditional methods like pay-back period. Modern methods of evaluation - 1RR and NPV - were not adopted. Thus the mills were not taking financing decisions in a scientific way. Budgetary control was not practiced. This had led to delay in completion of the projects on time and thereby led to escalation in the cost of project. It was also observed that the mills followed some crude methods of estimating working capital requirements. Cash flow estimates were not

11 278 systematically prepared well in advance to find out the sources from which the working capital was anticipated to flow. This has seriously impaird the working capital position of many of the mills, which in turn has forced the mills very often to go in for 'ways and means' advances from the government to meet and make up the deficit in working capital. Both the sugar and spinning mills did not have proper organizational set-up for financial management functions such as financial planing and control. Budgets were prepared in a traditional way. No scientific system was introduced. Cost standard and budgetary control systems will be of much use for exercising proper financial control. But unfortunately, mills seemed to have paid very little attention to these systems. Conclusion The overall performance of the sugar mills was not satisfactory, in spite of their better technical performance in terms of recovery and reduced overall extraction of sugar. This was mainly due to under-utilization of production capacity, unsound pricing policy and inefficient financial management of the mills. Majority of the cooperative spinning mills were running at loss. The major reasons for loss are under-utilization of the capacity, increase in cost of production, inefficient financial management, lack of sound management and want of democratic participation.

12 279 Suggestions The findings and conclusions on the performance of the cooperative sugar and spinning mills emphasize the need for better capacity utilization, bringing down the cost of production, improving the financial management practices and financial performance, redesigning the organizational structure and revival of democratic management. In cooperative sugar mills, besides the above aspects, there is an urgent need to review the policy relating to pricing of sugarcane and sugar. Better Capacity Utilization : The estimation of cane production should be realistically made at the time of selection of site for the installation of factory as well as at the time of expansion. The cooperative sugar mills should develop meaningful relationship with the members. Only then would they be able to have a legitimate claim on their loyalty. This in turn.wonl.d help in the flow of sugarcane to the factory on a regular and continuous basis. Agricultural development measures like liberal credit facitlity and effective agricultural extension service to the cane growers are necessary to improve the productivity and production of sugarcane. This in turn would assure regular supply of sugarcane to the cooperative sugar mills. The plant should also be kept in a state of efficiency in order to achieve fuller utilization of the capacity. Full capacity utilization in cooperative spinning mills is a formidable task. Various steps need to be taken for achieving full capacity utilization.

13 280 Some of them are : i) Data regarding capacity installed and utilized in respect of each production cost centre should be periodically checked to locate the degree of under-utilization and the reasons therefor, ii) To solve the problems of power shortage and power cut, generators should be installed. All the mills should make stand-by arrangements for generating electricity and thereby avoid adverse effects of power cuts that the State may impose from time to time. The State may also think of exempting cooperative spinning mills from power cut. iii) Many of the cooperative spinning mills are situated in rural areas at isolated places and do not have residential facilities both for technical personnel and the workers. adequate Unless this deficiency is removed, many mills may not, perhaps, be in a position to attract talented personnel. The mills may therefore take up housing programme with the financial assistance from HUDCO. and lockouts have also caused idleness in spindles. iv) Frequent strikes The strained relation between employer and employees could be reduced to a greater extent by associating the workers in vital areas of management such as production programmes, utilization of capacity, quality improvement and productivity improvement. They need to be educated on the imperative of regular attendance, reduction in waste, increase in spinning efficiency and so on. The spinning mills should also concentrate on the provision of welfare measures like better canteen facilities, recreational facilities, medical. ; care etc. This would go a long way in promoting labour efficiency. Bringing down the Cost of Production : The sugar mills may have no control over cost of sugarcane, an important component in cost of production

14 sugar, as sugarcane price is fixed by the government. Hence the areas where the cooperative sugar mills need to bestow their attention are better capacity utilization, recovery, improving the productivity of workers and administrative personnel, reduction in the cost of maintenance and repair and modernization of machinery. The economy of the cooperative spinning mills depends on the availability of cotton in the required quality and quantity at reasonable price. Eventhough the centralised procurement of cotton facilitates the purchase of quality cotton at a reasonable price, still there is vast scope for reducing the proportion of raw material cost in total turnover by appropriate mixing of cotton. single variety of cotton is used. Generally for production of any yarn no one The properties of different types of cotton vary in respect of staple length, fineness, maturity, strength and thrash content. An optimum blending of different varieties of cotton has to be determined taking into consideration the price of cotton, vis-a-vis its different properties. Hence in a way it is the optimum combination of economics and technology which helps to determine the right type of mixing for the particular count of yarn or group of counts of yarn to be manufactured. The quantum of waste that takes place during conversion process from cotton to yarn in the case of different varieties is also a material factor to be considered in the selection of cotton for the purpose of mixing, as it ultimately determines the expensiveness or inexpensiveness of the clean cotton cost in yarn. Thus avoiding of wastage, increasing the recovery of yarn and appropriate mixing of cotton may help in reducing the proportion of raw material cost in the total cost.

15 282 Another area which deserves attention is labour cost. The cooperative spinning mills in addition to the permanent strength of workers engage a few temporary workers in each department depending on the fluctuation in work load. In order to exercise proper control on the productive utilization of labour force, records should be maintained showing the number of persons engaged per 1000 spindles shifts. Improving Financial Management : Flexible budgets for various levels of capacity utilization should be prepared in a more scientific way and the actual performance should be reviewed against the estimates at periodic intervals to set right the deviation, if any. This requires the installation of budgetary control system in each mill. The techniques of ratio ; analysis and performance budgeting may be used by the department of finance to monitor the financial performance of the mills. A pragmatic financing policy for the mills would be to finance their ongoing operations with funds generated internally. This calls for strategic and operational measures to increase the internally generated cash surpluses. Adoption of' scientific planning and control of inventories, receivables, cash and continuous evaluation of mill's product-line by such techniques like contribution margin could go a long way to improve the cashflow situation on a lasting basis. Cashflow forecasts have to be prepared regularly and methodically and cashflow budgets drawn up on the basis of cashflor forecasts. All these presuppose the availability of correct and reliable data and a systematic feedback. It is, therefore, necessary that the cooperative sugar

16 283 and spinning mills should take steps to develop financial information system that can generate the required financial information for the purpose of financial planning and control. This also presupposes that the orientation of the accounts department must change from one of conventional accounting to that of financial management. All these necessitate the instalation of computers for processing management information. Revival of Democratic Control : The principle of democratic control which is the cardinal principle of cooperation should be restored in Tamil Nadu without any further delay. The special officers should be replaced by elected boards of directors in the cooperative sugar and spinning mills. The number of nominated directors in the Boards should not exceed 25 percent of the total directors. Nominated members should have no voting rights. Member education programmes should be launched in order to create awareness and enlightenment among the members. Reorganising Organization structure : The organizational set-up should be reorganized with reference to the requirements of effective professional management with a separate department for finance. This department should be manned by persons with professional qualifications and expertise in financial management. A costing section may be an integral part of the finance in each mill. Blending Democratic Control with Professional Management : The bye-laws may suitably be amended so as to redefine the powers and functions of the elected board and the chief executive. While the board should

17 284 concentrate on policy making and evaluation of performance of the effective management, the chief executive should be vested with adequate authority to discharge his managerial, operational and technical responsibilities. Pricing of Sugarcane : The unsound price policy should be replaced by a rational policy based on a proper balance between the interests of the growers and the consumers. An initial minimum price based on the minimum price fixed by the Central Government adjusted to local cost of cultivation may be paid to the growers at the time of delivery. Later, patronage dividend on supply may be paid out of the profits in proportion to the value of sugarcane supplied by the members. The payment of price according to the weight of sugarcane supplied is not a very sound strategy. The quality of cane in terms of sugar recovery should also be considered in fixing prices. It is desirable to promote the cultivation of high recovery varieties of sugarcane. Pricing of Sugar : The price of levy sugar should be related to the cost of production in different sugar zones. Capital Structure Findings The major sources of capital for cooperative sugar and spinning mills are share capital from members and government and borrowings from termlending institutions, the State Cooperative Bank and the State Government.

18 285 The shares in cooperative sugar mills are issued to members and the government. The ceiling on the contribution of share capital by the government is around 50 percent of the total paid-up share capital. Every producer member has to take at least one share for every one acre under sugarcane cultivation. The value of a share ranges from Rs.200 to Rs.250. The cooperative sugar mills augment the share capital by converting the nonrefundable deposits of members into share capital. The non-refundable deposits from the members are collected at the rate of Rs.7.50 per tonne of sugarcane supplied by the producer-members to the mills. Dividend payable to members is also converted into shares. Cooperative spinning mills issue shares to apex and primary weavers cooperative societies, other cooperative institutions and the government. The value of share is Rs.100. Both the categories of mills raise, long-term loans to meet the capital expenditure. Both the types of mills were not permitted to issue bonds or debentures. The cooperative sugar and spinning mills involve huge capital outlay. But their equity base is thin because they are organizations of economically weaker sections. Hence they have to rely heavily on long-term loans. The proportion of debt has been found to be as high as 75 percent in the capital structure of some of the mills especially during the initial years and periods of expansion. When the term loans were repaid in instalments by these mills, the proportion of debt declined and the proportion of equity in the capital structure increased. The average proportion of debt in the capital

19 286 structure of the cooperative sugar mills was percent in 1961-'62 which came down to percent in 1983-'84. The proportion of equity has increased from to percent during the same period. Similar trend was observed in cooperative spinning mills. But the cooperative sugar mills were able to bring down the proportion of debt to the lowest possible level by repaying the instalments of loans regularly, whereas the cooperative spinning mills could not do so because of their poor financial performance. The reserves are weak in both the types of mills. Most of the mills had no reserves especially during the period from 196i-'62 to The situation has improved in the subsequent period. But the proportion of reserves in equity was less than 10 percent in many of the mills. The position of reserves in cooperative spinning mills was much worse. The average proportion of Government's contribution in the paid-up share capital of cooperative sugar and spinning mills ranged from 25 to 45 percent and between 75 to 95 percent respectively. Thus the cooperative spinning mills have heavily relied upon State Government for their share capital. Conclusion The analysis of the capital structure of the selected cooperatives revealed that there was no set capital structure for the mills. The norm for debt-equity in early 60's and 70's was 2:1. It was revised to 1 : 1 in the beginning of the current decade. But this norm was not maintained in

20 287 many of the mills. There were variations within the industry and between the industries. Some mills had zero level of debt at some point of time whereas some have a debt proportion of more than 75 percent. Some had found it difficult to bring down the proportion of debt and therefore the debt was hovering at a high level. Suggestions The norms of debt equity ratio laid down for cooperative sugar and spinning mills should be strictly adhered to. Each mill should calculate its debt-equity ratio periodically keeping in mind the norms. All possible steps should be taken to strengthen the equity base. (For details, see the section on "Factors influencing and relationship between capital structure and cost of capital") Cost of Capital Findings The estimation of cost of capital in cooperative is different from that in a private enterprise. The shares of cooperatives have unique features. They are not transferable and are not traded in stock exchanges. They carry only a fixed nominal rate of interest depending on the amount of surplus available for distribution. Therefore the procedure for equating the market value with the present value of the expected benefits by a discount rate as followed in corporate sector cannot be adopted in cooperatives. Similarly,

21 288 the formula to calculate the cost of debt capital cannot be applied to cooperative because cooperatives borrow from rates and on different terms and conditions. several sources, at different Keeping these special aspects, a different appropriate approach was developed in this study for computing the cost of equity and debt. The cost of share capital in cooperatives is the average rate of dividend paid over the study period. The cost of debt is the weighted average cost of debt. The cost of retained earnings is calculated on the basis of opportunity cost, that is, the average rate of dividend that has been paid to the shareholders. The weighted average cost of capital is the summation of all the costs associated with acquiring cooperative capital. The cost of debt is costlier than the cost of share capital in both the categories of mills. The cost of debt ranged from 8 to 12 percent in both the mills. The average cost of debt for the cooperative sugar mills as a whole was percent and for spinning mills it was percent. The average specific cost of share capital for cooperative sugar mills was 6.U percent and that for cooperative spinning mills was 6.39 percent. Thus the average specific cost of debt was higher than that of share capital. The overall cost of capital was hovering around 6 to 10 percent in cooperative sugar mills and 4 to 8 percent in cooperative spinning mills at the initial stage. debt in instalments. This has subsequently declined due to repayment of Similarly the overall cost of capital was on the higher side in both the types of mills at the time of expansion and modernization,

22 289 but it declined later. It was also observed that many of the sugar mills were able to bring down the cost of capital at a quicker pace than the spinning mills. Conclusion The cost of debt was costlier than the cost of share capital and retained earnings. The overall cost of capital was found to be high at the initial stage and at the time of the expansion of capacity and modernization of plant. The behaviour of the cost of capital is influenced by financial leverage. Suggestions Suggestions for reducing the cost of capital are discussed in the section on "Factors influencing the relationship between capital structure and the cost of capital", Relationship Between Capital Structure and the Cost of Capital Findings Capital structure decision is concerned with the composition of capitalization, the relative proportions of various long-term sources of capital and the financial leverage. Financial leverage refers to the use' of fixed charge sources of funds such as debt and preference share capital in the capital structure. The basic logic behind financial leverage is that the owners of the firm will have the benefit of a higher rate of return on their capital

23 290 than that earned by the firm on its total capital through the use of fixed sources of funds, provided the rate of fixed charges is less than overall rate of return on the firm's total capital. Thus, financial leverage has a significant bearing on the composition of capital structure and the cost of capital. A firm can bring about a change in the cost of capital through changes in debt equity proportion in the total capital. The analysis of relationship between the capital structure and the cost of capital in sample cooperatives shows that there is a direct positive association between these variables. In the mills under study, the overall cost of capital tended to increase with a rise in the proportion of debt in the total capital ; and it recorded a declining trend with a fall in the proportion of debt, because in cooperatives debt is the costliest source of fund. The cost of debt is higher than the cost of share capital and retained earnings. Further the cost of debt is constant whereas the cost of share capital and retained earnings tend to reach zero level whenever the cooperatives pay no dividends. A rise in the proportion of debt, therefore, tends to increase the overall cost of capital. Conclusion Cost of capital in cooperative is a function of financial leverage. Cost of capital tends to rise with a rise in proportion of debt and it falls with a fall in proportion of debt in the capital structure.

24 291 Factors Influencing the Relationship Between the Capital Structure and the Cost of Capital Findings The cooperatives need to bring down the cost of capital in order to fulfill their objectives of extending services to their members at a reasonable cost. The cost of capital is greatly influenced by financial leverage, which in turn, is determined by several direct and indirect factors. The two direct factors which determine leverage are 'need for funds' and 'internal financing'. The Influence of 'Need for Funds' on Leverage : The need for funds arise when a firm is promoted ; when it is expanded/modernized ; and when it incurs social expenditure. The investment made during the establishment of a firm is called initial investment. The initial investment depends upon the capital intensiveness of the firm. The cooperative sugar and spinning mills are capital intensive in nature, requiring a huge capital outlay. The establishment of a cooperative sugar mill with a crushing capacity of 1250 TCD involved an outlay of Rs lakhs in The cost has increased steadily over a period of time and it stood at Rs.1020 lakhs in 1983-'84. Similarly the cost of establishing a cooperative spinning mill with a capacity of 12,000 spindles has increased from Rs.61 lakhs in 196<f-'65 to Rs.265 lakhs in 1984-'85. Thus the establishment of cooperative sugar/spinning mill requires huge amount of capital outlay which could not be met out of owned funds.

25 292 Hence the mills had to rely upon debt capital. Naturally the leverage was higher in the initial stages varying from 60 to 75 percent in the case of cooperative sugar mills and 60 to 67 percent in cooperative spinning mills. The remaining portion represents share capital only due to the absence of any reserves. An examination of composition of share capital revealed that a major chunk of share capital had been contributed by the government. Moreover, there was cost overrun in some mills to the Rs.6 to 10 lakhs because of delay in completing the project. extent of Thus, delay in commencing the production operations of the mills did have some, though not dramatic, effect on leverage. The additional investment depends upon the growth rate. The growth rate is influenced by expansion and modernization. Expansion/modernization also involves a considerable amount of capital expenditure. Higher growth rate would mean high amount of capital and greater proportion of capital has to be derived from debt sources. between growth rate and leverage. Thus, there is a positive association The results of the correlation also run in the expected direction, but the association is rather weak. The reason is that the selected mills have been able to finance their expansion/ modernization partly through internally generated funds during latter stages. The need for debt capital at the time of expansion/modernization is less when compared to the initial period.

26 293 Cooperative sugar mills were found to have launched various social welfare programmes like promotion of education, health and medical care within the area of operation of the mills. Spinning mills have not undertaken such activities. The expenditure incurred on social welfare by the cooperative sugar mills was financed mainly out of earnings before depreciation and also the Area Development Fund. As such the expenditure on social welfare does not affect leverage. The Influence of Internal Financing on Leverage : Internal financing is negatively correlated to leverage in the mills under study and this means the mills with retained earnings have been able to bring down the level of leverage and the mills which do not have retained earnings are operating at a higher level of leverage. Retained earnings or internal financing depends upon the profitability of the mills. Mills earning profits are able to generate internal funds. Thus profitability indirectly influences the level of leverage. Profitability itself, in turn, is influenced by a set of factors. Factors Affecting Profitability : The five variables considered for the indepth analysis are : i) capacity utilization ; ii) degree of operating leverage ; iii) total assets turnover, iv) fixed assets turnover and v) inventory turnover.

27 29<f fixed assets turnover and inventory turnover. This association is not quite unexpected. Whereas, in the case of cooperative spinning mills capacity utilization and fixed assets turnover are the only two factors associated with profitability. Multiple Correlation and Regression Analysis : The five variables namely capacity utilization, degree of operating leverage, total assets turnover, fixed assets turnover and inventory turnover, to which correlation analysis was applied, are also subjected to multiple correlation and regression analysis. The results show that the contribution of above factors to profitability was percent in cooperative suga'r mills. They also show that individually when other variables are kept constant only two variables namely fixed assets turnover and inventory turnover significantly influence profitability and these factors together account for percent of variations in profitability. Also, the standard regression coefficient indicates that fixed asset turnover is the most important followed by inventory turnover in the case of cooperative sugar mills. But in the case of cooperative spinning mills, the results of multiple correlation and regression analysis reveal that the percentage contribution of the five factors was only 7.3. Further-more the test of controlled association shows the fixed assets turnover only significantly influences profitability. Factors Influencing Gross Operating Margin : It was found that there was a close positive association between gross operating margin and profitability. Gross operating margin in turn is influenced by a set of variables,

28 295 namely, recovery, rate of change in cost of productio, rate of change in selling price and variability in sales in the case of cooperative sugar mills. The analysis shows that recovery is positively associated with gross operating margin as expected. The rate of change in cost of production is negatively correlated, as expected. The correlation between variability in sales and gross operating margin is negative and significant ; but it runs against the expectation. The rate of change in selling price had a weak association with gross operating margin. Multiple Correlation and Regression : All the four variables were also subjected to multiple correlation and regression analysis. The total contribution of four variables to gross operating margin was around 25 percent. The analysis also indicated that individually when other variables are kept constant, only three factors namely recovery, rate of change in cost of production and variability in sales significantly influenced gross operating margin and these factors together account for 23.6 percent of the variation in gross operating margin. The standard regression coefficient indicated that recovery is the most important factor followed by rate of change in cost of production and variability in sales. In cooperative spinning mills, only two variables namely rate of change in cost of production and variability in sales were analysed in the above fashion. The rate of change in cost of production did not correlate well with gross operating margin, whereas variability in sales had a positive and significant association with gross operating margin. When these two variables were put into multiple correlation and regression analysis, the total

29 296 contribution of these two variables to gross operating margin was only 7.H percent. Age and Leverage : Age is also determinant of leverage. A younger cooperative may require more amount of debt capital because of high cost of setting up a business coupled with low equity. On the other hand an older firm may be operating at a lower level of leverage because of successful operation and solvency. Age and leverage are negatively correlated in cooperative sugar mills indicating that younger firms have high debt level and the older firms have low debt level. But in cooperative spinning mills age and leverage are positively correlated. This was mainly because of the fact that many of them had unsuccessful operation and they were not successful in bringing down the level of debt over the years. Leverage in a Successful Cooperative A firm successful in its operation may retire its debt early thus bring down leverage level. The relation between successful operation and leverage revealed that a successful cooperative has attained lower leverage in lesser number of years than an unsuccessful cooperatives. Success was measured by profitability. This corroborates the fact that profitability and leverage are negatively correlated. Conclusion The findings of the study demonstrate that the cost of capital increases

30 297 as the leverage increases*., Many cooperatives were found to be operating at a higher level of leverage, hence the high cost of capital. High cost of capital coupled with poor profitability has rendered many of the mills under study financially weak. A financially weak cooperative cannot fulfill its objective of providing effective service at a reasonable cost. Thus there is an urgent need for bringing down the cost of capital. This can be done only by bringing down the level of debt in the capital structure. The level of debt or leverage is primarily influenced by the need for funds and the internal financing. Behind each of these variables as we have seen a host of other variables indirectly affect leverage. The mills need to bestow adequate attention to these variables in order to bring down the leverage. Presented below are some suggestions for bringing down the leverage and hence the cost of capital. Suggestions 1. Before launching a cooperative sugar/spinning mill or before expanding its capacity or before modernizing plant, the debt capacity of the mill has to be carefully studied by cashflow analysis. If the expected net cashflow is large enough to meet the estimated debt servicing cost it may resort to debt ; otherwise it may try to reduce the debt level as much as possible. This exercise was not carried out by many of the mills studied.

31 298 On completion of the projects, the mills never bothered to find out the deviations from the original cost estimate. Escalation of cost is bound to affect the leverage. Hence the mills need to conduct a post-project audit to analyse the cause of deviations and their effects ion future cashflow, debt servicing cost and the cost of capital. Such an analysis would help the management to know where exactly things have gone wrong and what remedial actions should be made. The Directorate of Sugar and the Directorate of Handloom and Textiles which have trained technical personnel may be entrusted with the responsibility of such a post-project audit. The mills relied heavily on debt at the time of their promotion. Such a high level of debt adversely affected their cost of capital and profitability. Hence it is suggested that the borrowings for fixed assets at the initial stages should not exceed 60 percent of the value of such fixed assets. be around 6 percent. The cost of capital at this debt level would The expansion and modernization may be financed by internally generated funds to the extent possible and borrowings for these purposes should not exceed 50 percent of the estimated outlay. The approximate cost of capital at this debt level would be around 5 percent. As any project overrun in cost and time adversely affects the earnings and the cost of capital, there should be an effective monitoring of project implementation.

32 299 Long-term loans raised for financing capital expenditures should be repaid as early as possible so as to reduce the level of leverage and the overall cost of capital. Some mills have resorted to 'ways and means' advance from the government in order to meet debt servicing cost. Such a practice has not only added to the debt burdens of the mills but also seriously affected their liquidity and working capital position. Hence it is absolutely necessary that the mills should meet fixed charges only out of their earnings. The ability of the mills to tolerate leverage depends on the stability of the net operating income. Mills with unstable income should try to avoid debt as much as possible. As low gearing i.e. a lower proportion of debt in the capital structure is a means for minimizing the cost of capital in cooperatives, they should aim at low gearing at least over a period of time. This could be achieved by collecting additional share capital from members in proportion to the value of their patronage (cane supplied/yarn purchased as the case may be), conversion of dividend on share capital and patronage into share capital with members' consent, and allocation of higher percentage of profits to reserves. Recurring and fixed deposits from the public may. also be accepted, as cost of this source is lower than that of borrowings.

33 300 9 Ownership and control should always be vested with members. Excessive state support in the form of share capital contribution to cooperative sugar and spinning mills has led to a dependency syndrome, affecting the democratic character and autonomy of the mills. Therefore mills should try to redeem the share capital subscribed by the government. A Share Capital Redemption Fund may be created in each mill to redeem the share capital contributed by the government. 10. The location of the mills especially sugar mills should be carefully considered. Their success largely depends on regular availability of adequate quantity of sugarcane throughout the season. The inadequate availability of raw material results in under-utilization of production capacity and this inturn affects the financial viability of the mills. Hence careful selection of site assumes greater significance. 11. Each mill should calculate the overall cost of capital in financing a project and compare it with the expected rate of return. But, no mill under study has given serious attention to this important aspect. The promoters of the new mills should get this exercise done through consultants. The viability of expansion/modernization should be scientifically evaluated by the finance department of the mill, if necessary, with the help of financial consultants. 12. The mills should take inflationary conditions into account and create Replacement Fund in addition to normal depreciation, in order to provide for adequate funds for replacing fixed assets when they go out of use. <'jf

34 The mills should try to improve their profitability by adopting effective methods of management and cost control techniques in order to bring down the cost per unit and increase profit margin. An improvement in financial performance would facilitate early redemption of debt and strengthening owned capital. 14. Mill should have sufficient working capital to operate the plant. Lack of sufficient working capital may lead to ineffective utilization of fixed assets, which, in turn, would affect profitability and thus leverage. Similarly mills should not seriously deplete its working capital at the time of expansion/modernization. Suggestions for Further Research Research studies in financial management in cooperatives are rare. There is vast scope for conducting research in financial management in cooperative organizations. Some of the areas for research in financial management in cooperatives are : 1. The status of financial management in various types of cooperatives and their financial management practices may be studied with a view to suggesting better approaches and methods. 2. In order to evaluate the financial performance of different types of cooperatives, norms for liquidity, operational efficiency etc. have to be established. Such norms are required for intra-firm and inter-firm comparisons.