Ok, here it is. We have to see the position of All Assets. eg. a company has Equity Sh. Capital of ₹5,00,000, Pref. Sh. Capital of ₹2,00,000, Free reserves of ₹6,00,000 and Creditors of ₹7,00,000 and the total of assets is ₹20,00,000. Now consider the security that creditors have before redemption of preference shares...if company decides to distribute full amount of free reserves as dividend to equity shareholders, the assets left will be ₹14,00,000 (20,00,000-₹6,00,000) and thus security of creditors is two times (14,00,000/7,00,000).
Now if preference shares are redeemed, assets will reduce to ₹18,00,000 and prefrence sh. capital will reduce to zero. Now security of creditors will be...12,00,000/7,00,000 i.e. less than two times. Now to maintain security of creditors, an amount equal to nominal capital of pref. sh. capital is transferred to crr (the purpose is to block free reserves so that the amount can't be used to distribute dividend). Now max. dividend can be 6,00,000-2,00,000=4,00,000 i.e the amount left in free reserves.
Now assets left if full free reserves are distributed as dividend...₹14,00,000 (₹18,00,000-₹4,00,000) and security of creditors is maintained at two times (14,00,000/7,00,000)
For any further queries, feel free to contact:
CA Tushar Dhingra
Email: catushardhingra @ gmail.com