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Management accounting notes @ mba bk

Management accounting notes @ mba bk



Management accounting notes @ mba bk

Management accounting notes @ mba bk



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    Management accounting notes @ mba bk Management accounting notes @ mba bk Document Transcript

    • LESSON – 1 INTRODUCTIONThe term “Management Accounting” is of recent origin. It was first coined by the BritishTeam of Accountants that visited the U.S.A. under the sponsorship of Anglo-AmericanProductivity Council in 195 with a view of highlighting utility of Accounting as an“effective management tool”. It is used to describe the modern concept of accounts as atool of management in contrast to the conventional periodical accounts prepared mainlyfor information of proprietors. The object is to expand the financial and statisticalinformation so as to throw light on all phases of the activities of the organisation.All techniques which aim at appropriate control, such as financial control, budgetedcontrol, efficiency in operations through standard costing, cost-volume-profit theory etc,are combined and brought within the purview of Management Accounting.Management Accounting evolves a scheme of accounting which lays emphasis on theplanning of future (logical forecasting), simultaneously finding the deviations betweenthe actual and standards. Another significant feature of Management Accounting isreporting to top-management. Finally, accounting information should be presented insuch a way as to assist the management in the formulation of policy and in the day-to-day conduct of business. For example, the published accounts of business concerns donot furnish management with information in a form that suggest the line on whichmanagement policies and actions should proceed. It requires further analysisclassification and interpretation before the management can draw lessons from them fortheir guidance and action.DEFINITION OF MANAGEMENT ACCOUNTINGManagement Accounting may be defined as “the presentation of accounting informationin such a way as to assist the management in the creation of the policy and day-to-dayoperation of an undertaking” – Management Accounting of the Anglo-American toproductivity.The Institute of Chartered Accountants of England has defined it –
    • “Any form of accounting which enables a business to be conducted more efficiently canbe regarded as Management Accounting”.Robert N. Anthony has defined Management Accounting as follows-“Management Accounting is concerned with accounting information that is useful tomanagement.”According to American Accounting Association, “Management Accounting includes themethods and concepts necessary for effective planning for, choosing among alternativebusiness actions and for control through the evaluation and interpretation ofperformance”. This definition is fairly illustrative.According to Kohler, Forward Accounting includes “Standard costs, budgeted costs andrevenues, estimates of cash requirements, break even charts and projected financialstatements and the various studies required for their estimation, also the internalcontrols regulating and safeguarding future operating.”Blending together into a coherent whole financial accounting, cost accounting and allaspects of financial management”. He has used this term to include “the accountingmethods, systems and techniques which, coupled with special knowledge and ability,assist manageme4nt in its task of maximizing profits or minimizing losses.” – JamesBatty.Thus all accounting which directly or indirectly providing effective tools to managers inenterprises and government organizations lead to increase in productivity is“Management Accounting.”OBJECTIVES OF MANAGEMENT ACCOUNTING:The basic objective of Management Accounting is to assist the management in carryingout its duties efficiently.The objectives of Management Accounting are:
    • 1. The compilation of plans and budgets covering all aspects of the business e.g., production, selling, distribution research and finance. 2. The systematic allocation of responsibilities for implementation of plans and budgets. 3. The organization for providing opportunities and facilities for performing responsibilities. 4. The analysis of all transactions, financial and physical, to enable effective comparisons to be made between the forecasts made and actual performance. 5. The presentations to management, at frequent intervals, of up-to-date information in the form of operating statements. 6. The statistical interpretation of such statements in a manner which will be of utmost assistance to management in planning future policy and operation.To achieve the above objectives, Management Accounting employs three principlesdevices, viz.,- 1. Forward Looking Principle – basis on the past and all other available data, forecasting the future and recommending wherever appropriate, the course of action for the future. 2. Target Setting Principle – fixation of an optimum target which is variously known as standard, budget etc., and through continuous review ensuring that the target is achieved or exceeded. 3. The Principle of Exception – instead of concentrating on voluminous masses of data, Management Accounting concentrates on deviations from targets (which are usually known as variances) and continuous and prompt analysis of the causes of these deviations on which to base management action.SCOPE OF MANAGEMENT ACCOUNTING:The scope of Management Accounting is wide and broad based. It encompasses withinits fold a searching analysis and branches of business operations. However, thefollowing facets of Management Accounting indicate the scope of the subject.
    • 1. Financial Accounting.2. Cost Accounting3. Budgeting & Forecasting4. Cost Control Procedure5. Statistical Methods6. Legal Provisions7. Organisation & Methods1. Financial Accounting: This includes recording of external transactions covering receipts and payments of cash, recording of inventory and sales and recognition of liabilities and setting up of receivables. It also preparation of regular financial statements. Without a properly designed accounting system, management cannot obtain full control and co-ordination.2. Cost Accounting : It acts as a supplement to financial accounting. It is concerned with the application of cost to job, product, process and operation. It plays an important role in assisting the management in the creation of policy and the operation of undertaking.3. Budgeting & Forecasting: These are concerned with the preparation of fixed and flexible budgets, cash forecast, profit and loss forecasts etc., in co-operation with operating and other departments. Management is helped by them.4. Cost Control Procedure: It is concerned with the establishment and operation of internal report in order to convert the budget in to operating service. Management is helped by them by measuring actual results budgetary standards of performance.5. Statistical Methods : These are concerned with generating statistical and analytical information in the form of graphs charts etc. of all department of the organization. Management need not waste time in understanding the facts and more time and energy can be utilized in sound plans and conclusions.6. Legal Provisions: Many management decisions depend upon the provisions of various laws and statutory requirements. For example, the decision to make a fresh issue of shares depends upon the permission of controller of capital issues. Similarly, the form of published accounts, the external audit the authority to float loans, the computation and verification of income, filing tax returns, making tax payments for excise, sales, payroll income etc., all depend on various rules and regulations passes from time to time.
    • 7. Organization & Methods: They deal with organization, reducing the cost and improving the efficiency of accounting as also of office operations, including the preparation and issuance of accounting and other manuals, where these will prove useful.It is clear that Management Accounting has a vital relation with all those areasexplained above.FUNCTIONS OF MANAGEMENT ACCOUNTING:The functions of management accounting may be said to include all activities connectedwith collecting, processing, interpreting and presenting information to management. TheManagement Accounting satisfies the various needs of management for arriving atappropriate business decisions. They may be described as follows: 1. Modification of Data:Accounting data required for decision – making purposes is supplied by managementaccounting through resort to a process of classification and combination which enablesto retrain similarities of details without eliminating the dissimilarities (e.g.) combination ofpurchases for different months and their breakup according to class of product, type ofsuppliers, days of purchase, territories etc. 2. Analysis & Interpretation of Data:The data becomes more meaningful with the analysis and interpretation. For example,when Profit and Loss account and Balance Sheet data are analyzed by means ofcomparative statements, ratios and percentages, cash-flow-statements, it will open upnew directions for its use by management. 3. Facilitating Management ControlManagement Accounting enables all accounting efforts to be directed towards control ofdestiny of an enterprise. The essential features in any system of control are thestandards for performance and measure of deviation therefrom. This is made possiblethrough budgetary control and standards costing which are an integral part ofManagement Accounting.
    • 4. Formulation of Business Budgets:One of the primary functions of management is planning. It is done by ManagementAccounting through the process of budgeting. It involves the setting up of objectives,and the selection of the most appropriate strategies by comparing them with referenceto some discriminating criteria. Probability, Probability, forecasting, and trends are someof the techniques used for this purpose. 5. Use of Qualitative Information:Management Accounting draws upon sources, other than accounting, for suchinformation as is not capable of being readily convertible into monetary terms. Statisticalcompilations, engineering records and minutes of meeting are a few such sources ofinformation. 6. Satisfaction of Informational Needs of Levels of Management:It serves management as a whole according to its requirements it serves top middle andlower level managerial needs to subserve their respective needs. For instance it has asystem of processing accounting data in a way that yields concise information coveringthe entire field of business activities at relatively long intervals for the top management,technical data for specialized personnel regularly and detailed figures relating to aparticular sphere of activity at short intervals for those at lower rungs of organizationalladder.The gist of Management Accounting can be expressed thus, it is a part of over allmanagerial activity – not something grafted on to it from outside – guiding and servicingmanagement as a body, to derive the best return form its resources, both the itself andfor the super system within which it functions.From the above discussions, one may come to the following conclusions about thefundamental approach in Management Accounting.Firstly, the Management Accounting functions is a managerial activity and it puts itsfinger in very pie without itself making them it guides and aids setting of objectives,planning coordinating, controlling etc. But it does not itself perform these functions.Secondly it serves management as a whole – top middle and lower level – according toits requirements. But in doing so it never fails in keeping in focus the macro-approach tothe business as a whole.
    • Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach is to splitall costs and benefits into two groups – measurable and non measurable. It is easy todeal with measurable costs which are expressed in terms of money. But there areseveral ventures such as office canteens where the cost-benefits may not be monetarilymeasurable.LIMITATIONS OF MANAGEMENT ACCOUNTINGComparatively, Management Accounting is a new discipline and is still very much in astate of evolution. There fore it comes across the same impediments as a relatively newdiscipline has to face-sharpening of analytical tools and improvement of techniquescreating uncertainty about their applications. 1. There is always a temptation to make an easy course of arriving at decision to intuition rather than taking the difficulty of scientific decision-making. 2. It derives its information from financial accounting, cost accounting and other records. Therefore, strength and weakness of Management Accounting depends upon the strength and weakness of basic records. 3. It is one thing to record, interpret and evaluate an objectives historical event converted into money figures, while it is something quite different to perform the same function in respect of post possibilities, future opportunities and unquantifiable situation. Execution of the conclusions drawn by the management accountant will not occur automatically. Therefore, a continuous effort to achieve the goal must be made at all levels of management. 4. Management Accounting will not replace the management and administration. It is only a toll of management. Of course, it will save the management from being immersed in accounting routine and process the data and put before the management the facts deviating from the standard in order to enable the management to take decisions by the rule of exception.
    • LESSON – 2 FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTINGThe terms financial accounting, and management accounting, are not prices descriptionof the activities they comprise. All accounting is financial in the sense that all accountingsystems are in monetary terms and management, of course, is responsible for thecontent of financial accounting reports. Despite this close interrelation, there are somefundamental differences between the two and they are: 1. Subject Matter : Managements need to focus attention on internal details is the origin of the basic differences between financial accounting and management accounting. In financial accounting, the enterprise as a whole is dealt with while, in management accounting, attention is directed towards various parts of the enterprise which is regarded mainly as a combination of these segments. Thus financial statements, like balance-sheets and income statements, report on the overall status and performance of the enterprise but most management accounting reports are concerned with departments products, type of inventories, sales or other sub-division of business entity. 2. Nature – Financial accounting is concerned almost exclusively with historical records whereas management accounting is concerned with the future plans and policies. Management’s interest in the past is only to the extent that it will be of assistance in influencing company’s future. The historical nature of financial accounting can be easily understood in the context of the purposes for which it was designed but management accounting does not end with the analysis of what has happened in the past and extends to the provision of information for use in improving results in future. 3. Dispatch – In Management Accounting, there is more emphasis on furnishing information quickly then is the case with financial accounting. This is so because up-to-date information is absolutely essential as a basis for management action and management accounting would lose much of its utility if information required the time lag between the end of accounting period and the preparation of accounting records for the same, it has not been, and cannot be, totally eliminated. 4. Characteristics – Financial accounting places great stress on those qualities in information which can command universal confidence, like objectivity, validity absoluteness, etc. whereas management accounting emphasizes those characteristics which enhance the value of information in a variety of uses, like flexibility, comparability etc. This difference is so important that a serious doubt has been raised as to whether both the types of characteristics can be preserved within the same framework. 5. Type of Data Used Financial accounting makes use of data which is historical
    • quantitative, monetary and objective, on the other hand management accounting used data which is descriptive, statistical subjective and relates to future. Therefore management accounting is not restricted, as financial accounting is, to the presentation of data that can be certified by independent auditors.6. Precision – There is less emphasis in precision in management accounting because approximations are often as useful as figures worked out accurately.7. Outside Dictates – As financial accounting ahs been assigned the role of a reference safeguarding the interests of different parties connected with the operation of a modern business undertaking, outside agencies have laid down standards for ensuring the integrity of information processed and presented in financial accounting statements. Consequently, financial accounting statements are standardized and are meant for external use. So, far as management accounting is concerned, there is no need for clamping down such standards for the preparation and presentation of accounting statements as management is both the initiator and user of data. Naturally, therefore, management accounting can be smoothly adapted to the changing needs of management.8. Element of compulsion – These days, for every business, financial accounting has become more or less compulsory indirectly if not directly, due to a number of factors but a business is free to install, or not to install, a system of management accounting.
    • LESSON – 3 FUNCTIONS OF FINANCIAL CONTROLLERThe gradual growth of management accounting has brought with it a recognition of thedesirability of segregating the accounting function from other activities of a secretarialand financial nature in order to make possible a more accurate accounting control overmultifarious, complex and sprawling business operations. As a natural corollary,controller has come into being by way of a skilled business analyst who, due to histraining and experience, is the best qualified to keep the financial records of thebusiness and to interpret these for the guidance of the management.It is not surprising, therefore, that controllership function has developed pari passu withthe development of management accounting so much so that there is a tendency torecord the two as synonymous. In a way, this is true because of controller in the UnitedStates does all that management accounting is expected to accomplish, in fact,controller is the pivot round which system of management accounting revolves.Generally speaking, controllership function embraces within its broad sweep and widecurves, all accounting functions including advice to management on course of action tobe taken in a given set of circumstances with the object of completely eliminating therole of intuition in business affairs.Concept:There is no precise concept of controllership as it is still in an evolutionary state. Even ifthe concept was possible of being described, it cannot be said that, wherever acontroller is in existence, he exercises all the functions that a theoretical controller isexpected to do because the real meaning of the term is dependent upon the agreementbetween him and the undertaking the seeks to serve. However, the controllers’ Instituteof America has drafted a seven-point concept of modern controllership. The hallmarksof the concept are: i. To establish, coordinate and administer, as an integral part of management, an adequate plan for the control of operations. Such a plan would provide, to the extent required in the business, for profit planning, programs for capital investing and financing, sales forecast, expense budgets and cost standards, together with the necessary procedure to effectuate the plan. ii. To compare performance with operating plans and standards and to report and interpret the results of operations to all levels of management and to the owners of business. This function includes the formulation and administration of
    • accounting policy and the compilation of statistical records and special reports as required. iii. To consult with all segments of management responsible for policy or action concerning any phase of the operations of business as it relates to the attainment of objectives and the effectiveness of policies, organization structure and procedures. iv. To administer tax policies and procedures. v. To supervise and coordinate the preparation of reports to governmental agencies. vi. To assure fiscal protection to the assets of the business through adequate internal control and proper insurance coverage.vii. To continuously appraise economic and social forces and government influences and interpret their effect on business.The controllers’ Institute, as well as the National Industrial conference Board of theUnited States, have spelt out the functions of the controller in still greater detail but theseven-point concept of modern controllership is board enough to leave no phase ofpolicy or organization beyond the controller’s jurisdiction. Through the concept has beenlaid down mainly from the functional point of view, it lifts the notion of controllership frompedestrian paper-shuffling to a top-management attitude that aids decision – making, itbroadens controller’s outlook and provides him with specific goals.Status of Controller:There is no fixed place for the controller in the hierarchy of management. It issometimes said that the status of controller is not ensured simply by virtue of his holdingthe office but depends, in no small measure, upon hi personality, mental equipment,industrial background and his capacity to convince others of his ability as well asintegrity. Moreover, it would depend upon the terms of his appointment and, therefore, itis bound to vary with every individual undertaking. The terms of appointment may befixed by the Board of Directors or may be included in the Articles of Association of theCompany.As a matter of general principle, all accounting functions, even though remotelyconnected with finance, are included in the responsibilities of the controller. As the chiefaccounting authority, the controller normally has his place in the top-level managementalong with the Treasurer who looks after bank accounts and the safe custody of liquidassets. Usually, the elevation of Controller to the post of Vice-President Finance intaken for granted and is considered only a routine matter.Modern Controller does not do any controlling, as is commonly understood, in terms of
    • line authority over other departments, his decision regarding the best accountingprocedures to be followed by line people are transmitted to the Chief Executive whocommunicates them by a manual of instructions coming down through line chain ofcommand to all people affected by the procedures.Limitation:It is also necessary that the limitation of Controller’s role imposed by the very nature ofhis work, must be borne in mind. Though the Controller helps in bringing together allphases of management, he does not pretend to solve the problems of production ofmarketing, he knows their nature and so can discuss in detail with all levels ofmanagement the financial implications of solutions they suggest.
    • LESSON – 4FINANCIAL STATEMENTS:According to the American Institute of Certified Public Accountants, “Financialstatements reflect a combination of recorded facts accounting conventions and personaljudgements and the judgements and conventions applied affect them materially.” Thisstatement makes clear that the accounting information as depicted by the financialstatements are influenced by three factors viz. recorded facts, accounting conventionsand personal judgements.OBJECTIVES OF FINANCIAL STATEMENTS: 1. To provide reliable information about economic resources and obligations of a business and other needed information about changes in such resources or obligations. 2. To provide reliable information about changes in net resource [resources less obligations] arising out of business activities and financial information that assits in estimating the earning potentials of business. 3. To disclose to the extent possible, other information related to the financial statements that is relevant to the needs of the users of these statements.USES AND USERS OF FINANCIAL STATEMENTS:Different classes of people are interested in the financial statement analysis with a viewto assessing the economic and financial position of any business or industrial concern interms of profitability, liquidity or solvency. Such persons and bodies include: 1. Shareholders 2. Debenture-holders 3. Creditors 4. Financial institutions and commercial banks 5. Prospective investors 6. Employees and trade unions 7. Tax authorities 8. Govt. departments 9. The company law board 10. Economists and investment analysis, etc.
    • IMPORTANCE OF FINANCIAL STATEMENTSIMPORTANCE TO MANAGEMENT:Financial statements help the management to understand the position, progress andprospects of business results. By providing the management with the causes ofbusiness results, they enable them to formulate appropriate policies and courses ofactions for the future. The management communicate only through these financialstatements their performance to various parties and justify their activities and therebytheir existence.IMPORTANCE TO THE SHAREHOLDERSThese statements enable the shareholders to know about the efficiency andeffectiveness of the management and also the earning capacity and the financialstrength of the company.IMPORTANCE TO LENDERS/CREDITORS:The financial statements serve as a useful guide for the present suppliers and probablelenders of a company. It is through a critical examination of the financial statements thatthese groups can come to know about the liquidity profitability and long-term solvencyposition of a company. This would help them to decide about their future course ofaction.IMPORTANCE TO LABOUR:Workers are entitled to bonus depending upon the size of profit as disclosed by auditedprofit and loss account. Thus, P & L a/c becomes greatly important to the workers inwage negotiations also the size of profits and profitability achieved are greatly relevant.IMPORTANCE TO PUBLIC:Business is a social entity. Various groups of the society, though not directly connectedwith business, are interested in knowing the position, progress and prospects of abusiness enterprise. They are financial analysts, lawyers, trade associations, tradeunions, financial press research scholars, and teachers, etc.Importance of National Economy: The rise & growth of the corporate sector, to agreat extent, influences the economic progress of a country. Unscrupulous & fraudulentcorporate managements shatters the confidence of the general public in joint stockcompanies which is essential for economic progress & retard economic growth of thecountry. Financial Statements come to rescue of general public by providing informationby which they can examine & asses the real worth of the company & avoid being
    • cheated by unscrupulous persons.Limitations of Financial Statements: 1. It shows only historical cost. 2. It does not take into account the price level changes. 3. It considers only monetary aspects but does not consider some vital non- monetary factors. 4. It is based on convention and judgement. Hence there is no accuracy. 5. Comparison of Financial Statements depends upon the uniformity of Accounting policies. 6. It is subject to window dressing.
    • LESSON – 5 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTSFinancial Statement are indicators of the two significant factors:(i) Profitability, and (ii) Financial soundnessAnalysis and interpretation of financial statements, therefore, refer to such a treatmentof the information contained in the income statement and the Balance Sheet so as toafford full diagnosis of the profitability and financial soundless of the business.TYPES OF FINANCIAL ANALYSISFinancial Analysis can be classified into different categories depending upon(i) The materials used and (ii) The modus operandi of analysisON THE BASIS OF MATERIAL USED: According to this basis financial analysis canbe of two types.(i) External Analysis: This analysis is done by those who are outsiders for thebusiness. The term outsiders includes investors, credit agencies, government and othercreditors who have no access to the internal records of the company.(ii) Internal Analysis: This analysis is done by persons who have access to the booksof account and other information related to the business.On the basis of modus operandi. According to this, financial analysis can also be twotypes.(i) Horizontal analysis: In case of this type of analysis, financial statements for anumber of years are reviewed and analyzed. The current year’s figures are comparedwith the standard or base year. The analysis statement usually contains figures for twoor more years and the changes are shown recording each item from the base yearusually in the from of percentage. Such an analysis gives the management considerableinsight into levels and areas of strength and weakness. Since this type of analysis isbased on the data from year to year rather than on the date, it is also termed as
    • Dynamic Analysis.(ii) Vertical analysis: In case of this type of analysis a study is made of the quantitativerelationship of the various terms in the financial statements on a particular date. Forexample, the ratios of different items of costs for a particular period may be calculatedwith the sales for that period such an analysis is useful in comparing the performance ofseveral companies in the same group, or divisions or departments in the samecompany.TECHNIQUES OF FINANCIAL ANALYSISA financial analyst can adopt one or more of the following techniques/tools of financialanalysis. 1. Comparative Financial Statements: Comparative financial statements are those statements which have been designed in a way so as to provide time perspective to the consideration of various elements of financial position embodied in such statements. In these statements figures for two or more periods are placed side by side to facilitate comparison. Both the income statement and Balance Sheet can be prepared in the form of Comparative Financial Statements.Comparative Income Statement: The Income statement discloses net profit or NetLoss on account of operations. A comparative Income Statement will show the absolutefigures for two or more periods, the absolute change from one period to another and ifdesired the change in terms of percentages. Since, the figures for two or more periodare shown side by side, the reader can quickly ascertain whether sales have increasedor decreased, whether cost of sales has increased or decreased etc. Thus, only areading of data included in Comparative Income Statements will be helpful in derivingmeaningful conclusions.Comparative Balance Sheet: Comparative Balance Sheet as on two or more differentdates can be used for comparing assets and liabilities and finding out any increase ordecrease in those items. Thus, while in a single Balance Sheet the emphasis is onpersent position, it is on change in the comparative Balance Sheet. Such a Balancesheet is very useful in studying the trends in an enterprise.
    • The preparation of comparative financial statements can be well understood with thehelp of the following illustration.ILLUSTRATION : From the following Profit and Loss Accounts and the Balance Sheetof Swadeshi polytex Ltd. For the year ended 31st December, 1987 and 1988, you arerequired to prepare a comparative Income Statement and Comparative Balance Sheet. PROFIT AND LOSS ACCOUNT (In Lakhs of Rs.)Particular 1987 1988 *Assets 1987 1988 Rs. Rs. Rs. Rs.To Cost of Goods sold 600 750 By Net 800 1,000 SalesTo operating ExpensesAdministrative Expenses 20 20Selling Expenses 30 40To Net Profit 150 190 800 1,000 800 1,000
    • BALANCE SHEET AS ON 31ST DECEMBER (In Lakhs of Rs.)Liabilities 1987 1988 Assets 1987 1988 Rs. Rs. Rs. Rs.Bills Payable 50 75 Cash 100 140Sundry Creditors 150 200 Debtors 200 300Tax Payable 6% 100 150 Stock 200 300Debentures 6% 100 150 Land 100 100Preference 300 300 Building 300 270CapitalEquity Capital 400 400 Plant 300 270Reserves 200 245 Furniture 100 140 1300 1520 1300 1520
    • SOLUTION: Swadeshi Polytex Limited COMPARATIVE INCOME STATEMENT FOR THE YEARS ENDED 31ST DECEMBER AND 1988 (In Lakhs of Rs.) Absolute Percentage increase or increase or decrease in decrease in 1988 1988 1987 1988Net Sales 800 1000 +200 +25Cost of Goods 600 750 +150 +25SoldGross Profit 200 350 +50 +25Operating 20 20 - -ExpensesAdministrationExpensesSelling 30 40 +10 +33.33ExpensesTotal Operating 50 60 10 +20ExpensesOperating Profit 150 190 +40 +26.67
    • Swadeshi Polytex Limited COMPARATIVE BALANCE SHEET AS ON 31ST DECEMBER, 1987, 1988 Figures in lakhs of rupeesAssets 1987 1988 Absolute Percentage increase or increase (+) decrease or decrease during 1988 (-) during 1988Current Assets:Cash 100 140 40 +40Debtors 200 300 100 +50Stock 200 300 100 +50Total Current Assets 500 740 240 +50Fixed Assets:Land 100 100 - -Building 300 270 -30 -10%Plant 300 270 -30 -10%Furniture 100 140 +40 +40%Total Fixed Assets 800 780 -20 -2.5%Total Assets 1300 1520 220 +17%Liabilities &Capital:Current LiabilitiesBills Payable 50 75 +25 +50%Sundry Creditors 150 200 +50 +33.33%Tax Payable 100 150 +50 +50%Total Current 300 425 +125 +41.66%LiabilitiesLong-term Liabilities : 100 150 +50 +50%6%DebenturesTotal Liabilities 400 575 +175 +43.75%
    • Capital & Reserves6% Pre. Capital 300 300 - -Equity Capital 400 400 - -Reserves 200 245 45 22.5Total Shareholders’ 900 945 45 5%FundsTotal Liabilities and 1300 1520 220 17%Capital 2. Common – size Financial Statements: Common – size Financial Statements are those in which figures reported are converted into percentages to some common base. In the Income Statement that sale figure is assumed to be 100 and all figures are expressed as a percentage of this total.Illustration: Prepare a Common – size Income Statement & Common-size BalanceSheet of Swadeshi Polytex Ltd., for the years ended 31st December, 1987 & 1988SOLUTION: Swadeshi Polytex Limited COMMON – SIZE INCOME STATEMENT FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988 (Figures in Percentage) 1987 1988Net Sales 100 100Cost of Goods Sold 75 75Gross Profit 25 25Opening Expenses:Administration Expenses 2.50 2Selling Expenses 3.75 4Total Operating Expenses 6.25 6Operating Profit 18.75 19Interpretation: The above statement shows that though in absolute terms, the cost ofgoods sold has gone up, the percentage of its cost to sales remains constant at 75%,
    • this is the reason why the Gross Profit continues at 25% of sales. Similarly, in absoluteterms the amount of administration expenses remains the same but as a percentage tosales it has come down by 5%. Selling expenses have increased by 25%. This all leadsto net increase in net profit by 25% (i.e., from 18.75% to 19%)
    • 3. Trend Percentage: Trend Percentages are immensely helpful in making a comparative study of the Financial statements for several years. The method of calculating trend percentages involves the calculation of percentage relationship that each item bears to the same item in the base year. Any year may be taken as base year. It is usually the earliest year. Any intervening year may also be taken as the base year. Each item of base year is taken as 100 and on that basis the percentages for each of the years are calculated. These percentages can also be taken as Index Numbers showing relative changes in the financial data resulting with the passage of time.The method of trend percentages is useful analytical device for the managementsince by substitution percentages for large amounts, the brevity and readabilityare achieved. However, trend percentages are not calculated for all of the itemsin the financial statements. They are usually calculated only for major items sincethe purpose is to highlight important changes.Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis are theother tools of Financial Analysis which have been discussed in detail as separatechapters.
    • LESSON – 6 RATIO ANALYSISMeaning and Nature of ratio analysisThe term “ratio” simply means one number expressed in terms of another. It describesin mathematical terms the quantitative relationship that exists between two numbers,the terms “accounting ratio”. J. Batty points out, is used to describe significantrelationships between figures shown on a Balance Sheet, in a Profit and Loss Account,in a Budgetary control System or in any other Part of the accounting organisation. RatioAnalysis, simply defined, refers to the analysis and interpretation of financial statementsthrough ratios. Nowadays it is used by all business and industrial concerns in theirfinancial analysis. Ratio are considered to be the best guides for the efficient executionof basic managerial functions like planning, forecasting, control etc.Ratios are designed to show how one number is related to another. It is worked out bydividing one number by another. Ratios are customarily presented either in the form of acoefficient or a percentage or as a proportion. For example, the current Assets andcurrent Liabilities of a business on a particular date are Rs. 2.5 Lakhs and Rs. 1.25lakhs respectively. The resulting ratio of current Assets and current Liabilities could beexpressed as (i.e. Rs. 2,00,000/1,25,000) or as 200 per cent. Alternatively in the form ofa proportion the same ratio may be expressed as 2:1, i.e. the current assets are twotimes the current liabilities.Ratios are invaluable aids to management and others who are interested in the analysisand interpretation of financial statements. Absolute figures may be misleading unlesscompared, one with another. Ratios provide the means of showing the relationshipwhich exists between figures. Though there is no special magic in ratio analysis, manyprefer to base conclusions on ratios as they find them highly useful for makingjudgments more easily. However, the numerical relationships of the kind expressed byratio analysis are not an end in themselves, but are a means for understanding thefinancial position of a business. Generally, simple ratios or ratios compiled from a singleyear financial statements of a business concern may not serve the real purpose. Hence,ratios are to be worked out from the financial statements of a number of years.Ratios, by themselves, are meaningless. They derive their status partly from theingenuity and experience of the analyst who uses the available data in a systematicmanner. Besides, in order to reach valid conclusions, ratios have to be compared withsome standards that are established with a view to represent the financial position ofthe business under review. However, it should be borne in mind that after computing theratios one cannot categorically say whether a particular ratio is god or bad as the
    • conclusions may vary from business to business. A single ideal ratio cannot be appliedfor all types of business. Speedy compiling of ratios and their presentations in theappropriate manner are essential. A complete record of ratios employed in advisableand explanation of each, and actual ratios year by year should be included. This recordmay be treated as a part of an Accounts Manual or a special Ratio Register may bemaintained.CLASSIFICATION OF RATIOS:Ratios can be classified into different categories depending upon the basis ofclassification.The traditional classification has been on the basis of the financial statement to whichthe determinants of a ratio belong. On this basis of ratios could be classified as: 1. Profit and loss Accounts Ratios, i.e. ratios calculated on the basis of the items of the Profit and Loss account only e.g. Gross Profit ratio, stock turnover ratio, etc. 2. Balance sheet ratios, i.e., ratio calculated on the basis of figures of Balance sheet only, e.g., current ratio, debt-equity etc. 3. Composite ratios or inter-statements ratios, i.e., ratio on figures of profit and loss account as well as the balance sheet, e.g. fixed assets turnover ratio, overall profitability ratio etc.However, the above basis of classification has been found to be guide and unsuitablebecause analysis of Balance sheet and Balance sheet and income statement can notbe done in insalaion. The have to be studied together in order to determine theprofitability and solvency of the business. In order that ratios serve as a toll for financialanalysis, they are now classified as:(1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financial ratios,(a) Liquidity Ratios (b) Stability Ratios.
    • LESSON – 7PROFITABILITY RATIOS:Profitability is an indication of the efficiency with which the operations of the businessare carried on. Poor operational performance may indicate poor sales and hence poorprofits. A lower profitability may arise due to the lack of control over the expenses.Bankers, financial institutions and other creditors look at the profitability ratios indicatorwhether or not the firm earns substantially more than it pays interest for the use ofborrowed funds and whether the ultimate repayment of their debt appears reasonablycertain. Owners are interested to know the profitability as it indicates the return whichthey can on their investments. The following are the important profitability ratios: 1. OVERALL PROFITABILITY RATIOS:It is also called “Return on investment” (ROI) or Return On Capital Employed (ROCE) itindicates the percentage of return on the total capital employed in the business. It iscalculated on the basis of the following formula. Operation Profit x 100 ------------------------------- Capital employedThe term capital employed has been given different meanings by different accountants.Some of the popular meanings are as follows: i) Sum-total of all assets whether fixed or current ii) Sum-total of fixed assets iii) Sum-total of long-term funds employed in the business, i.e.,Share capital + Reserves & Surplus + Long Term loans + Non business assets +Fictitious assets.In Management accounting, the term capital employed is generally used in the meaninggiven in the third point above.The term “Operating profit” means “Profit before Interest & Tax.” The term “Interested”means “Interested on long term borrowing”. Interest on short – term borrowings will bededucted for computing operating profit. Non-term borrowing will be deducted forcomputing operating profit. Non-trading incomes such as interested on Government
    • securities or non-trading losses or expenses such as loss on account of fire, etc., willalso be excluded. 2. Return on Shareholders “Funds”: In case it is desired to work out the profitability of the company from the shareholders point of view, it should be computed as follows: Net Profit after interest & tax ---------------------------------------- x 100 Shareholders’ FundsThe term Net Profit here means “Net Incomes after Interest & Tax” It is different fromthe “Net Operating Profit” Which is used for computing the “Return on Total CapitalEmployed” in the business. This because the shareholders are interested in TotalIncome after Tax including Net Non-operating Income (i.e., Non-operating Income –Non-operating Expenses) 3. Fixed dividend Cover: This ratio is important for preference shareholders entitled to get dividend at a fixed rate in priority to other shareholders. The ratio is calculated as follows: Net Profit after Interest & tax Fixed dividend cover = ------------------------------------------------- Preference dividend 4. Debt service coverage ratio: The interest coverage ratio, as explained above, does not tell us anything about the ability of a company to make payment of principle amounts also on time. For this purpose debt service coverage ratio is calculated as follows: Net Profit before interest & tax Debt service coverage ratio = --------------------------------------------------- Principal Payment Instalment Interest + ----------------------------------------- 1 – (Tax rate)The principle payment instalment is adjusted for tax effects since such payment is notdeductible from net profit for tax purposes.
    • Net Profit Before Interest & Tax 5. Interest Coverage Ratio = ------------------------------------------------------- Interest Charges Gross Profit 6. Gross Profit Ratio = ------------------------------------------------- x 100 Net Sales Net Profit 7. Net Profit Ratio = ------------------------------------------------ x 100 Net Sales Operating Profit Operating Profit Ratio = -------------------------------------------- x 100 Net SalesOperating Profit = Net Profit + Non-Operating expenses – Non – operating income Operating Cost 9. Operating Ratio = --------------------------------- x 100 Net Sales Amount available to Equity Shareholders 10. Earnings Per Share (EPS) = ------------------------------------------------------------ Number of Equity Shares Market Price per Share 11. Price – Earnings (P/E) Ratio = ------------------------------------------- Earning Per Share
    • LESSON – 8 1. Fixed assets turnover ratio : This ratio indicates the extent to which the investments in fixed assets contribute towards sales. If compares with a previous period, it indicates whether the investment in fixed assets has been judicious or not. The ratio is calculated as follows: Net Sales --------------------------------- Fixed Assets (NET) 2. Working Capital Turnover Ratio: This is also known as Working Capital Leverage Ratio. This ratio indicates whether or net working capital has been utilized in making sales. In case a company can achieve higher volume of sales with relatively small amount of working capital, it is an indication of the operating efficiency of the company. The ratio is calculated as follows. Net Sales ---------------------------------- Working CapitalWorking capital turnover ratio may take different forms for different purposes. Some ofthem are being explained below:(i) Debtors” turnover ratio (Debtors, Velocity): Debtors constitute an importantconstituent of current assets and therefore the quality of debtors to a great extentdetermines a firm’s liquidity. Two ratios are used by financial analysis to judge theliquidity of a firm. They are (i) Debtor’s turnover ratio, and (ii) Debt collection periodratio.The Debtor’s turnover ratio is calculated as under: Credit sales --------------------------------------------- Average accounts receivableThe term Accounts Receivable include “Trade Debtors” and Bill Receivable”.In case details regarding and closing receivable and credit sales are not available the
    • ratio may be calculated as follows: Total Sales --------------------------------------------- Accounts ReceivableSignificance: Sales to Accounts Receivable Ratio indicates the efficiency of the staffentrusted with collection of book debts. The higher the ratio, the better it is, Since itWould indicate that debts are being collected more promptly. For measuring theefficiency, it is necessary to set up a standard figure, a ratio lower then the standard willindicate inefficiency.The ratio helps in Cash Budgeting, since the flow of cash form customers can beworked out on the basis of sales.(ii) Debt collection Period ratio: The ratio indicates the extent to which the debts havebeen collected in time. It gives the average debt collection period. The ratio is veryhelpful to the lenders because it explains to them whether their borrowers are collectingmoney within a reasonable time. An increase in the period will result in greater blockageof funds in debtors. The ratio may be calculated by any of the following methods. Months (or days) in a year (a) ---------------------------------------------------- Debtors’ turnover Average Accounts Receivable x Months (or days) in a year (b) -------------------------------------------------------------------------------------- Credit sales for the year Accounts receivable (c) ------------------------------------------------------------------- Average monthly or daily credit salesIn fact, the two ratios are interrelated Debtor’s turnover ratio can be obtained by dividingthe months (or days)In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the numberof months (or days) in a year are divided by the debtors turnover, average debt
    • collection period is obtained (i.e., 12/6 – 2 months)Significance: Debtors’ collection period measures the quality of debtors since itmeasures the rapidity or slowness with which money is collected from them. A shortcollection period implied prompt payment by debtors. It reduces the chances of baddebts.A longer collection period implies too liberal and inefficient credit collectionperformance. However, in order to measure a firm’s credit and collection efficiency itsaverage collection period should be compared with the average of the industry. It shouldbe neither too liberal nor too restrictive. A restrictive policy will result in lower saleswhich will reduce profits.It is difficult to provide a standard collection period of debtors. It depends upon thenature of the industry, seasonable character of the business and credit policies of thefirm. In general, the amount of receivables should not exceed a 3-4 months’ creditsales.(iii) Creditors’ turnover ratio (Creditors’ velocity): It is similar to debtors ‘TurnoverRatio. It indicates the speed with which the payment for credit purchases are made tothe creditors. The ratio can be computed as follows: Credit Purchases ------------------------------------------- Average accounts payableThe term Accounts payable include “Trade Creditors” and “Bills payable”In case the details regarding credit purchases, opening closing accounts payable havenot been given, the ratio may be calculated as follows: Total Purchases ---------------------------------- Account Payable(iv) Debt payment period enjoyed ratio (Average age of payable):The ratio give the average credit period enjoyed from the creditors. It can be computedby any one of the following methods:
    • Month’s or days in a year(a) --------------------------------------------------- Creditors’ turnover Average accounts payable x Months (or days) in a year(b) ---------------------------------------------------------------------------------------- Credit purchases in the year Average accounts payable(c) ------------------------------------------------------------------------- Average monthly (or daily) credit purchasesSignificance: Both the creditors turnover ratio and the debt payment period enjoyedratio indicate about the promptness or otherwise in making payment of creditpurchases. A higher “creditors turnover ratio” or a “lower credit period enjoyed ratio”.Signifies that the creditors are being paid promptly, thus enhancing the creditworthiness of company. However, a very favourable ratio to this effects also shows thatthe business is not taking full advantage of credit facilities which can be allowed by thecreditors.Stock Turnover Ratio: This ratio indicate whether investments in inventory is efficientlyused or not. It therefore, explains whether investment in inventories is within properlimits or not. The ratio is calculated as follows:Cost of goods sold during the year------------------------------------------------------Average inventoryAverage inventory is calculated by taking stock levels of raw materials work – in –process, finished goods at the end of each months, adding them up and dividing bytwelve.Inventory ratio can be calculated regarding each constituent of inventory. It may thus becalculated regarding raw materials, Work in progress & finished goods. Cost of goods sold1* --------------------------------------------------
    • Average stock of finished goods Materials consumed2** ---------------------------------------------- Average stock of raw materials Cost of completed work3*** ------------------------------------------ Average work in progressThe method discussed above is as a matter of fact the best basis for computing thestock Turnover Ratio. However, in the absence of complete information, the inventoryTurnover Ratio may also be computed on the following basis. Net sales ------------------------------------------------- Average inventory at selling PricesThe average inventory may also be calculated on the basis of the average of inventoryat the beginning and at the end of the accounting period. Inventory at the beginning of the accounting period + Inventory at the end of the accounting periodAverage Inventory = -------------------------------------------------------------------------------------- 2Significance: As already stated, the inventory turnover ratio signifies the liquidity of theinventory. A high inventory turnover ratio indicates brisk sales. The ratio is, therefore, ameasure to discover the possible trouble in the form of overstocking or overvaluation.The stock position is known as the graveyard of the balance sheet. If the sales are quicksuch as a position would not arise unless the stocks consists of unsalable items. A lowinventory turnover ratio results in blocking of funds in inventory becoming obsolete ordeteriorating in quality.It is difficult to establish a standard ratio of inventory because it will differ from industry.However, the following general guidelines can be given.
    • (i) The raw materials should not exceed 2-4 months’ consumption of the year.(ii) The finished goods should not exceed 2-3 months’ sales(iii) Work in progress should not exceed 15-30 days’ cost of sales.PRECAUTIONS: While using the Inventory Ratio, care must be taken regarding thefollowing factors:(i) Seasonable conditions: If the balance sheet is prepared at the time of slackseason, the average inventory will be much less (if calculated on the basis of inventoryat the beginning of the accounting period & inventory at close of the accounting period).This may give a very high turnover ratio.(ii) Supply conditions: In case of conditions of security inventory may have to be keptin high quality for meeting the future requirements.(iii) Price trends: In case of possibility of a rise in prices, a large inventory may be keptby business. Reverse will be the case if there is a possibility of fall in prices.(iv) Trend of volume of business: In case there is a trend of sales being sufficientlyhigher than sales in the past, a higher amount of inventory may be kept.
    • LESSON – 9FINANCIAL RATIOSFinancial Ratios indicate about the financial position of the company. Accompany isdeemed to be financially sound if it is in a position to carry on its business smoothly andmeetits obligions, both short – term as well as longterm, without strain. It is a soundprinciple of finance that the short-term requirements of funds should be met out of shortterm funds and long-term requirements should be met out of long-term funds. Forexample if the payment for raw materials purchases are made through the issuedebentures it will create a permanent interest burden on the enterprise. Similarly, if fixedassets are purchased out of funds provide by bank overdraft, the firm will come to griefbecause such assets cannot be sold away when payment will be demanded by thebank.Financial ratios can be divided into two broad categories: (1) Liquidity Ratios & (2) Stability Ratios(1) LIQUIDITY RATIOS: These ratios are termed as “working capital” or “short-termsolvency ratios”. As enterprise must have adequate working-capital to run its day-to-dayoperations. Inadequacy of working capital may bring the entire business operation to agrinding halt because of inability of enterprise to pay for wages, materials & otherregular expenses.CURRENT RATIOS: This ratio is an indicator of the firm’s commitment to meet itsshort-term liabilities. It is expressed as follows: Current assets ----------------------------- Current LiabilitiesCurrent assets mean assets that will either be used up or converted into cash within ayear’s of time or normal operating cycle of the business, whichever is longer. Currentliabilities means liabilities payable within a year or operating cycle, whichever is longer,out of existing current assets or by creation of current liabilities. A list of items include incurrent assets & current liabilities has already been given in the performs analysisbalance sheet in the preceding chapter.Book debts outstanding for more than six months & loose tools should not be included
    • in current assets. Prepaid expenses should be taken as current assets.An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of solvency dueto the fact that if the current assets are reduced to half, i.e., 1 instead of 2, then also thecreditors will be able to get their payments in full. However a business having seasonaltrading activity may show a lower current ratio at a creation period of the year. A veryhigh current ratio is also not desirable since it means less efficient use of funds. This isbecause a high current ratio means excessive dependence on long-term sources ofraising funds. Long-term liabilities are costlier than current liabilities & therefore, this willresult in considerably lowering down the profitability of the concern.It is to be noted that the mere fact current ratio is quite high does not mean that thecompany will be in position to meet adequately its short-term liabilities. In fact, thecurrent ratio should be seen in relation to the component of current assets & liquidity. Ifa large portion of the current assets comprise obsolete stocks or debtors outstanding fora long term, time, the company may fail even if the current ratio is higher then 2.The current ratio can also be manipulated very easily. This may be done either by eitherpostponing certain pressing payments or postponing purchase of inventories or makingpayment of certain current liabilities.Significance: The current ratio is an index of the concern’s Financial stability since itshows the extent of working capital which is the amount by which the current assetsexceed the current liabilities. As stated earlier, a higher current ratio would indicateinadequate employment of funds while a poor current ratio is a danger signal to themanagement. It shows that business is trading beyond its resources.(II) QUICK RATIO: This ratio is also termed as “acid test ratio” or “liquidity ratio”. Thisratio is ascertained by comparing the liquid assets (i.e., assets which are immediatelyconvertible into cash without much loss) to current liabilities prepaid expenses and stockare not taken as liquid assets. The ratio may be expressed as: Liquid assets --------------------------- Current liabilitiesSome accountants prefer the term “Liquid Liabilities” for “Current Liabilities” or thepurpose of ascertaining this ratio. Liquid liabilities means liabilities which are payablewithin a short period. The bank over-draft (if it becomes a permenant mode of financing)& cash credit faculties will be excluded from current liabilities in such a case.
    • The ideal ratio is 1.This ratio is also an indicator of short-term solvency of the company.A comparison of the current ratio to quick ratio shall indicate the inventory hold-ups. Forexample if two units have the same current ratio but different liquidity ratio, it indicatesover-stocking by the concern having low liquidity ratio as compared to the concernwhich has a higher liquidity ratio.Thus, debtors are excluded from liquid assets for the purpose of comparing super –quick ratio. Current liabilities & liquid liabilities have the same meaning as explainedabove. The ratio is the more measure of firms’ liquidity position. However, it is notwidely used in practice.STABILITY RATIO: These ratios help in ascertaining long term solvency of a firm whichdepends basically on three factors:(i) Whether the firm has adequate resources to meet its long term funds requirements.(ii) Whether the firm has used an appropriate debt-equity mix to raise long-term funds.(iii) Whether the firm earns enough to pay interest & instalment of long-term loans intime.The capacity of the firm to meet the last requirement can be ascertained by computingthe various coverage ratios, already explained in the preceding pages. For the other tworequirements, the following ratios can be calculated.(1) FIXED ASSETS RATIO: This ratio explains whether the firm has raised adequatelong-term funds to meet its fixed assets requirements. It is expressed as follows: Fixed assets --------------------------- Long – Term fundsThe ratio should not be more than 1. If it is less than 1, it shows that a part of the
    • working capital has been financed through long-term funds. This is desiarable to someextent because a part of working capital termed as “Core Working Capital” is more orless is a fixed nature. The ideal ratio is 67.(ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capital structure offirm is made up or the debt-equity mix adopted by the firm. The following ratios fall inthe category.(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportionbetween fixed interest or dividend bearing funds & non-fixed interest or dividend bearingfunds in the total capacity employed in the business. The fixed interest or dividendbearing funds include the funds provided by the debenture holders & preferenceshareholders. Non-fixed interest or dividend bearing funds are the funds provided by theequity shareholders. The amount, therefore, includes the Equity Share Capital & otherReserves. A proper proportion between the two funds is necessary in order to keep thecost of capital at the minimum. The capital gearing ratio can be ascertained as follows: Funds bearing fixed interest or fixed dividend -------------------------------------------------------------------- Equity Shareholder’s Funds(b) DEBT-EQUITY RATIO: The debt-equity ratio is determined to ascertain thesoundness of the long-term financial position of the company. It is also known as“External – Internal” equity ratio. Total long-term debt Debt – Equity Ratio = ------------------------------------------ Shareholder’s fundsSignificance: The ratio indicates the preparation of owners’ stake in the business.Excessive liabilities tend to cause insolvency. The ratio indicates the extent to which thefirm depends upon outsiders for its existence. The ratio provides a margin of safety tothe creditors. It tells the owners the extent to which they can gain the benefits ormaintain control with a limited investment.(c) Proprietary ratio : It is a variant of debt-equity ratio. It establishes relationshipbetween the proprietor’s funds & the total tangible assets. It may be expressed as:
    • Shareholder’s funds = -------------------------------- Total tangible assetsSignificance: This ratio focuses the attention on the general financial strength of thebusiness enterprise. The ratio is of particular importance to the creditors who can findout the proportion of shareholders funds in the total assets employed in the business. Ahigh proprietary ratio will indicate a relatively little danger to the creditor’s etc., in theevent of forced reorganization or winding up of the company. A low proprietary ratioindicates greater risk to the creditors since in the event of losses a part of their moneymay be lost besides loss to the properties of the business. The higher the rate, thebetter it is. A ratio below 50 percent may be alarming for the creditors since they mayhave to lose heavily in the event of company’s liquidation on account of heavy losses. ADVANTAGES OF RATIO ANALYSISFollowing are some of the advantages of ratio analysis: 1. Simplifies financial statements: Ratio Analysis simplified the comprehension of financial statements. Ratios tell the whole story of changes the financial condition of the business. 2. Facilitates inter-firm comparison: Ratio Analysis provides date for inter-firm comparison. Ratios highlight the factors associated with successful & unsuccessful firms. They also reveal strong firms & weak firms, over-valued & under valued firms. 3. Makes intra-firm comparision possible: Ratio Analysis also makes possible comparision of the performance of the different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past & likely performance in the future. 4. Helps in planning: Ratio Analysis helps in planning & forecasting. Over a period of time a firm or industry develops certain norms that may indicate future success or failure. If relationship changes in firms data over different time periods, the ratios may provide clues on trends and future problems. Thus “Ratio can assist management in its basic functions of forecasting planning coordination, control and communication”.LIMITATIONS OF ACCOUNTING RATIOS
    • 1. Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with the past results of the business or with the results of a similar business. However, such a comparision only provides a glimpse of the past performance and forecasts for future may not be correct since several other factors like market conditions, management policies, etc. may affect the future operations. 2. Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements which suffer from a number of limitations.For example non-financial charges though important for the business are not revealedby the financial statements. If the management of the company changes, it may haveadverse effect on the future profitability of the company but this cannot be judged byhaving a glance at the financial statements of the company.Financial statements show only historical cost but not market value.The comparision of one firm with another on the basis of ratio analysis without takinginto account the fact of companies having different accounting policies will bemisleading and meaningless. 3. Ratios alone are not adequate : Ratios are only indicators they cannot be taken as final regarding good or bad financial position of the business Other things have also to be seen. 4. Window dressing: The term window dressing means manipulations of accounts in a way so as to conceal vital facts and present the financial statements in a way to show a better position than what it actually is. On account of such a situation presence of a particular ratio may not be a definite indicator of good or bad management. 5. Problem of price level changes: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account. 6. No fixed standards: No fixed standards can be laid down for ideal ratios. For example, current ratio is generally considered to be ideal if current assets are twice the current liabilities. However, in case of these concerns which have adequate arrangements with their bankers for providing funds when they require, it may be perfectly ideal if current assets are equal to slightly more than current liabilities. 7. Ratios area composite of many figures: Ratios are a composite of many different figures. Some cover a time period, others are at an instant of time while still others are only averages. A balance sheet figures shows the balance of the
    • account at one moment of one day. It certainly may not be representative of typical balance during the year. It may, therefore, be conducted that ratio analysis, if done mechanically, is not only misleading but also dangerous.The computation of different accounting ratios & the analysis of the financial statementson their basis can be very well understood with the help of the illustrations given in thefollowing pages: COMPUTATION OF RATIOSIllustration 1: Following is the Profit and Loss Account and Balance Sheet of Jai HindLtd., Redraft the for the purpose of analysis and calculate the following ratios: i. Gross Profit Ratios ii. Overall Profitability Ratio iii. Current Ratio iv. Debt-Equity Ratio v. Stock Turnover Ratios vi. Liquidity Ratios PROFIT AND LOSS ACCOUNT Db. Cr.ParticularsOpening stock of finished 1,00,000 Sales 10,00,000goodsOpening stock of raw 50,000 Closing stock of raw 1,50,000materials materialsPurchase of raw materials 3,00,000 Closing stock of finished 1,00,000 goodsDirect wages 2,00,000 Profit on sale of shares 50,000Manufacturing expenses 1,00,000Administration expenses 50,000
    • Selling & Distribution 50,000expensesLoss on sale of plant 55,000Interest on Debentures 10,000Net Profit 3,85,000 13,00,000 13,00,000 BALANCE SHEETLiabilities Rs. Assets Rs.Share Capital: Fixed Assets 2,50,000Equity Share Capital 1,00,000 Stock of raw materials 1,50,000Preference share capital 1,00,000Reserves 1,00,000 Stock of finished 1,00,000Debentures 2,00,000 Sundry debtors 1,00,000Sundry Creditors 1,00,000 Bank Balance 50,000Bills Payable 50,000 6,50,000 6,50,000SOLUTION: INCOME STATEMENT
    • Sales Rs. 10,00,000Less: Cost of salesRaw material consumed (op. Stock + Purchases – 2,00,000Closing Stock)Direct Wages 2,00,000Manufacturing expenses 1,00,000Cost of production 5,00,000Add: Opening stock of finished goods 1,00,000 6,00,000Less: Closing stock of finished goods. Cost of goods 1,00,000 5,00,000soldGross Profit 5,00,000Less: Operating Expenses:Administration expenses 50,000Selling and distribution expenses 50,000 1,00,000Net operating profit 4,00,000Add: Non-trading income: 50,000Profit on sale of shares 4,50,000Less: Non-trading expenses or losses:Loss on sale of plant 55,000Income before interest & tax 3,95,000Less: Interest on debentures 10,000Net Profit before tax 3,85,000 BALANCE SHEET (OR POSITION STATEMENT) Rs.
    • Bank balance 50,000Sundry debtors 1,00,000Liquid assets 1,50,000Stock of raw materials 1,50,000Stock of finished goods 1,00,000Current assets 4,00,000Sundry creditors 1,00,000Bills Payable 50,000Current liabilities 1,50,000Working Capital (Rs. 4,00,000 – Rs. 1,50,000) 2,50,000Add Fixed assets 2,50,000Capital employed 5,00,000Less Debentures 2,00,000Shareholders’ net worth 3,00,000Less Preference share capital 1,00,000Equity shareholders’ net worth 2,00,000Equity shareholders’ net worth is represented by: 1,00,000Equity Share capital 1,00,000Reserves 2,00,000Ratios: Gross Profit x 100 50,000 x 100 (i) Gross Profit Ratio ---------------------------- -------------------------- = 50% Sales 10,00,000 Operating Profit x 100 4,00,000 x 100 (ii) Overall Profitability Ratio = ------------------------------- = --------------------- = 80% Capital employed 5,00,000 Current assets 4,00,000
    • (iii) Current Ratio = ------------------------------- = -------------------------- = 2.67 Current liabilities 1,50,000 External equities 3,50,000(iv) Debt Equity Ratio: = -------------------------- = --------------------- = 1.17 Internal equities 3,00,000 (or) Total long- term debt 2,00,000 ------------------------------ = ----------------- = 0.40 Total long-term funds 5,00,000 (or) Total long-term debt 2,0,00,000 ----------------------------- = -------------------- = 0.67 Shareholders’ funds 3,00,000(v) Stock turnover ratio: Cost of goods sold 5,00,000(a) As regards average total inventory = ---------------------------- = ----------------- = 2.5 Average inventory* 2,00,000(*) of raw materials as well as finished goods)(b) As regards average inventory of finished goods: Cost of goods sold 5,00,000 -------------------------------------------------- = ---------------- = 5 Average inventory of finished goods 1,00,000(c) As regard average inventory of raw materials:
    • Materials consumed 2,00,000 -------------------------------------------------- = ---------------- = 2 Average inventory of materials 1,00,000 Liquid assets 1,50,000(iv) Liquid Ratio: ------------------------- = ----------------- = 1 Current liabilities 1,50,000ILLUSTRATION 2 : Following are the ratios to the trading activities of National TradersLtd. Debtor’s Velocity 3 Months Stock Velocity 8 Months Creditor’s Velocity 2 Months Gross Profit Ratio 25 percentGross profit for the year ended 31st December, 1988 amount to Rs. 4,00,000/- closingstock of the year is Rs. 10,000 above the opening stock. Bills receivable amount to Rs.25,000 and Bills payable to Rs. 10,000.Find out: (a) Sales, (b) Sundry Debtors; (c) Closing Stock & (d) Sundry CreditorsSOLUTION : (a) Sales: Gross profit Gross Profit Ratio = ------------------------- x 100 SalesGross profit = Rs. 4,00,000/-
    • 4,00,000Sales = ----------------------------- x 100 = Rs. 16,00,000 25 (b) Sundry Debtors : Debtor’s Debtor’s Velocity = --------------------- x 12 Sales“Debtor’s Velocity of 3 months” Presumably means that Accounts Receivable equal to 3months’ Sales or ¼ of the year’s sales. Rs. 1,60,000Account Receivable = --------------------- x 1 4,00,000 4Less Bills Receivable 25,000 -------------------------Sundry Debtors 3,75,000 ------------------------- (c) Closing Stock: Cost of goods sold Stock Velocity = ------------------------------------------ Average stock Cost of goods sold = Sales – Gross profit = 16,00,000 – 4,00,000 = Rs. 12,00,000 12,00,000 Average Stock = ------------------------- x 8 = Rs. 8,00,000
    • 12 Total of Opening and Closing stock = 8,00,000 x 2 = 16,00,000 Closing Stock is higher than Opening Stock by Rs. 10,000 16,00,000 - 10,000 Therefore, Opening Stock = --------------------------------- 2 = 7,95,000Hence, Closing Stock = 7,95,000 + 10,000 or Rs. 8,05,000 (d) Sundry Creditor’s: Total Creditor’s Creditor’s Velocity i.e., = ------------------------------ x 12 PurchasesPurchases = Cost of goods sold + Closing Stock – opening Stock = 12,00,000 + 8,05,000 – 7,95,000 = Rs. 12,10,000Creditor’s Velocity is 2 months, it means that Account Payable are 1/6th of thePurchases for the yearHence Account Payable = Rs. 2,01, 667Less : Bills Payable = 10,000 --------------------Sundry Creditor’s Rs. 1,91,667 --------------------
    • LESSON – 10 FUNDS FLOW ANALYSISThe technique of Funds Flow Analysis is widely used by the financial analyst, creditgranting institutions and financial managers in performance of their jobs. It has becomea useful tool in their analytical kit. This is because the financial statements, i.e., “IncomeStatement” and the “Balance Sheet” have a limited role to perform. Income statementmeasures flow restricted to transactions that pertain to rendering of goods or services tocustomers. The Balance Sheet is merely a static statement. It is a statement of assetsand liabilities which does not focus major financial transactions which have been behindthe balance sheet changes. One has to draw inferences after comparing the balancesheets of two periods. For example, if the fixed assets worth Rs. 2,00,000 arepurchased during the current year by raising share capital of Rs. 2,00,000 the balancesheet will simply show a higher capital figure and higher fixed assets figure. In case,one compares the current year’s balance sheet with the previous year, then only onecan draw an inference that fixed assets were acquired by raising share capital of Rs.2,00,000. Similarly, certain important transaction which might occur during the course ofthe accounting year might not find any place in the balance sheet. For example, if a loanof Rs. 2,00,000 was raised and paid in the accounting year the Balance sheet will notdepict this transaction. However, a financial analyst must know the purpose for whichthe loan was utilized and the source from which it was raised. This will help him inmaking a better estimate about the company’s financial position and policies.The term “fund” generally refers to cash, to cash and cash equivalents, or to workingcapital. Of these the last definition of the term is by far the most common definition of“fund”.There are also two concepts of working capital – gross and net concept. Gross workingcapital refers to the firm’s investment in current asset while the term net working capitalmeans excess of current assets over current liabilities. It is in the latter sense in whichthe term ‘funds’ is generally used.Current Assets: The term ‘Current Assets’ includes assets which are acquired with theintention of converting them into cash during the normal business operations of thecompany.The broad categories of current assets, therefore, are 1. Cash including fixed deposits with banks. 2. Accounts receivable, i.e., trade debtors and bills receivable, 3. Inventory i.e., stocks of raw materials, work-in-progress, finished goods, stores
    • and spare parts. 4. Advances recoverable, i.e., the advances given to supplier of goods and services or deposit with government or other public authorities, e.g., customer, port authorities, advance income tax, etc. 5. Pre-paid expenses, i.e. cost of unexpired services e.g., insurance premium paid in advance, etc.Current Liabilities: The term ‘Current Liabilities’ is used principally to designate suchobligations whose liquidation is reasonably expected to require the use of assetsclassified as current assets in the same balance sheet or the creation of other currentliabilities or those expected to be satisfied within a relatively short period of time usuallyone year. However, this concept of current liabilities has now undergone a change. Themore modern version designates current liabilities as all obligations that will requirewithin the coming year or the operation cycle, whichever is longer. The use of existingcurrent assets or the creation of other current liabilities . in other words, the more factthat an amount is due within a year does not make it current liability unless it is payableout of existing current assets or by creation of current liabilities. For exampledebentures due for redemption within a year of the balance sheet date will not be takenas a current liability if they are to be paid out of the proceeds of a fresh issue of shares /debentures or out of the proceeds realized on account of sale of debentures redemptionfund investments.The term current liabilities also includes amounts set apart or provided for any knownliability of which the amount cannot be determined with substantial accuracy e.g.,provision for taxation, pension etc., These liabilities are technically called provisionsrather than liabilities.The broad categories of current liabilities are: 1. Accounts payable e.g., bill payable and trade creditors. 2. Outstanding expenses, i.e., expenses for which services have been received by the business but for which the payment has not made. 3. Bank-over drafts. 4. Short-term loans, i.e., loans from banks, etc., which are payable within one year from the date of balance sheet. 5. Advance payments received by the business for the services to be rendered or goods to be supplied in future. 6. Current maturities of long-term loans, i.e., long-term debts due within a year of the balance sheet date or installments due within a year in respect of these loans, provided payable out of existing current assets or by creation of current
    • liabilities, as discussed earlier. However, installments of long-term loans due after a year should be taken as non-current liabilities.Meaning of “Flow of Funds” The term “Flow” means change and therefore, the term“Flow of Funds” means “Change in Funds” or “Change in working capital”. In otherwords, any increase or decrease in working capital means “Flow of Funds”.USES OF FUNDS FLOW A STATEMENTFunds flow statement helps the financial analyst in having a more detailed analysis andunderstanding of changes in the distribution of resources between two balance sheetdates. In case such study is required regarding the future working capital position of thecompany, a projected funds flow statement can be prepared. The uses of funds flowstatement can be put as follows. 1. It explains the financial consequences of business operations. Funds flow statement provides a ready answer to so many conflicting situations, such as: • Why the liquid position of the business is becoming more and more unbalanced inspite of business making more and more profits. • How was it possible to distribute dividends in excess of current earnings or in the presence of a new loss for the period? • How the business could have good liquid position in spite of business making losses or acquisition of fixed assets? • Where have the profits gone?Definite answers to these questions will help the financial analyst in advising hisemployer / client regarding directing of funds to those channels which will be mostprofitable for the business. 2. It answers intricate queries. The financial analyst can find out answers to a number of intricate questions. • What is the overall credit-worthiness of the enterprise? • What are the sources of prepayment of the loans taken? • How much funds are generated through normal business operations?
    • • It what way the management has utilized the funds in the past and what are going to be likely use of funds? • It acts as an instruments for allocation of resources. • It is a test as to effective or otherwise use of working capital .PREPARATION OF FUNDS FLOW STATEMENTIn order to prepare a Funds Flow Statement, it is necessary to find out the “sources”and “applications” of funds.Sources of funds. The sources of funds can be both internal as well as external. Internal Sources: Funds from operations is the internal source of funds. However, following adjustments will be required in the figure of Net Profit for finding out real funds from operations. Add the following items as they do not result in outflow of funds: 1. Depreciation on fixed assets 2. Preliminary expenses or goodwill, etc., written off. 3. Contribution of debenture redemption find, transfer to general reserve, etc, if they have been deducted before arriving at the figure of net profit. 4. Provision for taxation and proposed dividend are usually taken as appropriations of profits only and not current liabilities for the purposes of Funds Flow Statement. This is being discussed in detail later. Tax or dividends actually paid are taken as applications of funds. Similarly, interim dividend paid is shown as an applications of funds. All these items will be added back to net profit, if already deducted, to find funds from operations. 5. Loss on sale of fixed assets.Deduct the following items as they do not increase funds; 1. Profit on sale of fixed assets since the full sale proceeds are taken as a separate source of funds and inclusion here will result in duplications. 2. Profit on revaluation of fixed assets. 3. Non-operating incomes such as dividend received or accrued dividend, refund of income tax, rent received or accrued rent. These items increase funds but they are non-operating incomes. They will be shown under separate heads as ‘source of funds’ in the Funds Flow Statement.
    • In case the profit and Loss Account shows “Net Loss”, this should be taken as an itemwhich decreases the funds.External Sources: These sources includes- 1. Funds from long-term loans 2. Sale of fixed assets 3. Funds from increase in share capital 4. Application of funds 5. Purchase of fixed assets 6. Payment of dividends 7. Payment of fixed liabilities. 8. Payment of tax liability.Technique for preparing a funds flow statementA funds flow statement depicts change in working capital. it will, therefore, be better forthe students to prepare first a Schedule of Changes in Working Capital before preparinga funds flow statement.Schedule of changes in working capitalThe schedule of changes in working capital can be prepared by comparing the currentassets and the current liabilities of two periods. It may be in the following form.
    • SCHEDULE OF CHANGE IN WORKING CAPITALItems As As on Change --- --- Increase Decrease (+) (-)Current AssetsCash balanceBank balanceMarketable securitiesAccounts receivableStock-in-tradePrepaid expensesCurrent LiabilitiesBank overdraftOutstanding expensesAccounts payableNet Increase / Decrease in Working CapitalRules for preparing the Schedules: 1. Increase in a current asset, result in increase (+) in “working capital” 2. Decrease in current asset, results in decrease (-) in “working capital” 3. Increase in a current liability, results in decrease (-) in “Working capital” 4. Decrease in a current liability, results in increase (+) in “Working capital”Funds – flow statement While preparing a funds flow statement, current assets and current liabilities are to be ignored. Alternation is to be given to changes in Fixed Assets and Fixed Liabilities. The statement may be prepared in the following form.
    • FUNDS FLOW STATEMENTSources of funds: Rs. Application of Funds Rs.Issue of Shares --- Redemption of Redeemable ---Issue of Debentures --- Preference Shares ---Long-term Borrowing --- Redemption of Debentures ---Sale of Fixed Assets --- Payment of other long-term loans ---Operating profit* --- Operating Loss* ---Decrease in working capital --- Payment of dividend, tax, etc. --- Increase in working capital* ----* Only one figure will be there.The change in working capital disclosed by the ‘schedule of changes in working capitalwill tally with the change disclosed by the ‘funds flow statement’.Illustration 1:From the following balance sheet of X Ltd. On 31st December 1985 and 1986, you arerequired to prepare. 1. A schedule of changes in working capital 2. A funds flow statement
    • Liabilities 1985 1986 Assets 1985 1986 Rs. Rs. Rs. Rs.Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000General Reserve 14,000 18,000 Building 40,000 36,000Profit & Loss A/c 16,000 13,000 Plant 37,000 36,000Sundry Creditors 8,000 5,400 Investments 10,000 11,000Bills Payable 1,200 800 Stock 30,000 23,400Provision for 16,000 18,000 Bill Receivable 2,000 3,200TaxationProvision for 400 600 Debtors 18,000 19,000doubtful debts Cash at Bank 6,600 15,200 1,55,600 1,55,800 1,55,600 1,55,800The following additional information has also been given. 1. Depreciation charged on Plant was Rs. 4,000 and on Building Rs. 4,000 2. Provision for taxation of Rs. 19,000 was made during the year 1986. 3. Interim dividend of Rs. 8,000 was paid during the year 1986.
    • SCHEDULE OF CHANGES IN WORKING CAPITAL 1985 1986 Increase Decrease (+) (-)Current Assets: Rs. Rs. Rs. Rs.Cash at Bank 6600 15200 8600Debtors 18000 19000 1000Bills receivable 2000 3200 1200Stock 30000 23000Current Liabilities 6600Provision for doubtful debts 400 600 200Bills payable 1200 800 400 ---Sundry Creditors 8000 5400 2600 ---Total 13800 6800FUNDS FLOW STATEMENTSources Rs.Funds from operations 36000Total sources 36000Applications: Rs.Purchase of plant 3000Tax paid 17000Investments purchased 1000Interim dividend paidTotal application 29000Net increase in working capital 7000
    • Working Notes: 1. Funds from operations: Rs. Rs.Profit & Loss account balance on 31st Dec., 1986 13000Add: Items which do not decrease funds fromOperationsTransfer to General Reserve 4000Provision for Tax 19000Depreciation:Plant 4000Building 4000Interim Dividend paid 8000 39000 52000Less: Profit & Loss balance on 31st Dec., 1988 16000Funds from operations for the year 36000 2. Purchase of Plant. This has been found out by preparing the Plant Account.Plant AccountTo balance b/d 37000 By Depreciation 4000To bank 3000 By balance c/d 36000(Purchase of plant balancing figure) 40000 40000 3. Tax paid during the year has been found out by preparing a Provision for Tax Account.Provision For Tax AccountTo blank By balance b/d 16000(being tax paid – balancing figure) 17000 By P & L A/c 19000To balance c/d 18000 35000 35000
    • 4. ‘Investment’ have been taken as a fixed asset presuming that they are long-term investment.
    • LESSON – 11 CASH FLOW ANALYSISCash flow analysis is another important technique of financial analysis. It involvespreparation of Cash flow statement for identifying sources and applications of cash. Acash flow statement is a statement depicting change in cash position from one period toanother. For example, if the cash balance of business is shown by its Balance sheet on31st December, 1978 at Rs. 20,000 while the cash balance as per its balance sheet on31st December, 1979 is Rs. 30,000. There has been an inflow of cash of Rs. 10,000 inthe year 1979 as compared to the year 1978. The cash flow statement explains thereasons for such inflows or outflows of cash, as the case may be. It also helpsmanagement in making plans for the immediate future.A cash flow statement can be prepared on the same pattern on which a funds flowstatement is prepared. The change in the cash position from one period to another iscomputed by taking into account “Sources” and “Application” of cash.Format of a Cash Flow StatementA cash flow statement can be prepared in the following form:
    • Cash Flow Statement For the year ending on ...Balance as on 1.1.19...Cash balance ......Bank balance ......Issue of Shares .....Raising of long-term loans ......Sale of fixed assets ......Short-term borrowings ......Cash from operation ......Profit as per Profit and Loss Account ......Add/Less : Adjustment for non-cash itemsAdd: Increase in current liabilitiesDecrease in current assets ......Less: Increase in current assets .....Decrease in current liabilities ......Total cash available (1)Less: Application of Cash:Redemption of redeemable preference ......sharesRedemption of long-term loans ......Purchase of fixed assets ......Decrease in deferred payment liabilities ......Cash outflow on account of operation ......Tax paid ......Dividend paid ......Decrease in unsecured loans, deposits etc., ......Closing balances*Cash balance ......Bank Balance ...... * There total should tally with the balance as shown by (1) – (2)
    • DIFFERENCE BETWEEN CASH FLOW ANALYSIS AND FUNDS FLOW ANALYSISFollowing are the points of difference between a Cash Flow Analysis and a Fundsanalysis. 1. A cash flow statement is concerned only with the change in cash position while a funds flow analysis is concerned with changed in working capital position between two balance sheet dates. Cash is only one of the constituents of working capital besides several other constituents such as inventories, accounts receivable, prepaid expenses. 2. A cash flow statement is merely a record of cash receipts and disbursements. Of course, it is valuable in its own way but if fails to bring to light many important changes involving he disposition of resources. While studying the short-term solvency of a business one is interested not only in cash balance but also in the assets which are easily convertible into cash. 3. Cash flow analysis is more useful to the management as a tool of financial analysis in short period as compared to funds flow analysis. It has rightly been said that shorter the period covered by the analysis, greater is the importance of cash flow analysis. For example, if it is to be found out whether the business can meet it obligations maturing after 10 years from now, a good estimate can be made about firm’s capacity to meet its long-term obligations if changes in working capital position on account of operations are observed. However, if the firm’s capacity to meet a liability maturing after one months is to be seen, the realistic approach would be to consider the projected change in the cash position rather than an expected change in the working capital position. 4. Cash is part of working capital and, therefore, an improvement in cash position results in improvement in the funds position but the reverse is not true. In other words, “inflow of cash” results in ‘inflow of funds’ but inflow of funds may not necessarily result in “inflow of cash”. Thus, a sound funds position does not necessarily mean a sound position but a sound cash position generally means a sound funds position. 5. Another distinction between a cash flow analysis and a funds flow analysis can be made on the basis of the techniques of their preparation. An increase in a current liability or decrease in a current asset results in decrease in working capital and vice verse. While an increase in a current liability or decrease in a current asset (other than cash) will result in increase in cash and vice versa.Some people, as stated before, use of term “funds” in a very narrow sense of ‘cash’only. In such an event the two terms ‘Funds’ and ‘Cash’ will have synonymous meaning.
    • UTILITY OF CASH FLOW ANALYSIS 1. Helps in efficient cash management 2. Helps in internal financial management 3. Discloses the movement of cash 4. Discloses success or failure of cash planningLIMITATIONS OF CASH FLOW ANALYSIS 1. Cash flow statement cannot be equated with the Income Statement. An income statement takes into account both cash as well as non-cash items and, therefore, net cash flow does not necessarily mean net income of the business. 2. The cash balance as disclosed by the cash flow statement may not represent the real liquid position of the business since it can be easily influenced by postponing purchases and other payments. 3. Cash flow statement cannot replace the Income Statement or the Funds flow statement. Each of them has a separate function to perform.Illustration 1From the following balances you are required to calculate cash from operations: Debtors 1987 1988 Rs. Rs.Bills receivable 50,000 47,000Creditors 10,000 12,000Bills payable 20,000 25,000Outstanding expenses 8,000 6,000Prepaid expenses 1,000 1,200Prepared expenses 800 700Accrued Income 600 750Income received in advance 300 250Profit made during the year .... 1,30,000
    • CASH FROM OPERATIONSProfit made during the year .... 1,30,000Add:Decrease in Debtors 3000Increase in Creditors 5000Increase in outstanding expenses 100 8300Less:Increase in Bills Receivable 2500Decrease in Bills payable 2000Increase in Accrued Income 150Decrease in Income received in advance 50 4700Cash from operation 133600Illustration 2:Balance Sheets of A and B on 1.1.1988 and 31.12.1988 were as follows:BALANCE SHEET 1.1.88 31.12.88 1.1.88 31.12.88Liabilities Rs. Rs. Assets Rs. Rs.Creditors 40,000 44,000 Cash 10,000 50,000Mrs. A’s 25,000 .... Debtors 30,000 50,000LoanLoan from 40,000 50,000 Stock 35,000 25,000BankCapital 1,25,000 1,53,000 Machinery 80,000 55,000 Building 35,000 60,000 2,30,000 2,47,000 2,30,000 2,47,000During the year of a machine costing Rs. 10,000 (accumulated depreciation Rs. 3,000)was sold for Rs. 5,000. The provision for depreciation against Machinery as on 1.1.1988was Rs. 25,000 and on 31.12.1988 Rs. 40,000. Net profit for the year 1988 amounted toRs. 45,000. You are required to prepare Cash Flow Statement.
    • SolutionCash Flow StatementCash balance as on 1.1.1988 Rs. 10,000Add: SourcesCash from Operations Rs. 59,000Loan from Bank 10,000Sale of Machines 5,000 74,000 8,400Less: Applications:Purchase of Land 10,000Purchase of Building 25,000Mrs. A’s Loan repaid 25,000Drawings 17,000 77,000Cash Balance as on December 31, 1988 7,000Working NotesCASH FROM OPERATIONSProfit made during the year Rs. 45,000Add: Depreciation on Machinery 18,000Loss on Sale of Machinery 2,000Decrease in Stock 10,000Increase in Creditors 4,000 34,000 79,000Less: Increase in Debtors 20,000Cash from Operation 59,000
    • Machinery Account (At Cost)To Balance b/d 1,05,000 By Bank 5,000 By Loss on Sale of machinery 2,000 By provision for Depreciation 3,000 By balance c/d 95,000 1,05,000 1,05,000PROVISION FOR DEPRECIATIONTo machinery A/c 3,000 By balance b/d 25,000To balance c/d 40,000 By P & L A/c 18,000 (depreciation charged – balancing figure) 43,000 43,000
    • LESSON 12 BUDGETS AND BUDGETARY CONTROLThe management is efficient if it is able to accomplish the objective of the enterprise. Itis efficient when it accomplishes the objectives with minimum effort and cost. In order toattain long-range efficiency and effectiveness, management must chart out its course inadvance. A systematic approach to facilitate effective management performances profit-planning and control, or budgeting. Budgeting is therefore an integral part ofmanagement. In a way, a budgetary control system has been described as a historicalcombination of a “goal – setting machine for increasing an enterprise’s profits, and agoal-achieving machine for facilitating organizational coordination and planning whileachieving the budgeted targets.”DefinitionsThe Institute of Cost and Management Accountants, London, gives the followingdefinitions:A budget is “a financial and / or quantitative statement, prepared and approved prior toa defined period of time, of the policy to be pursued during that period for the purpose ofattaining a given objective. It may include income, expenditure and the employment ofcapital.*Budgetary control. “The establishment of departmental budgets relating theresponsibilities of executive to the requirements of a policy, and the continuouscomparison of actual with budgeted results, either to secure by individual action theobjectives of the policy, or to provide a firm basis for its revision.”Thus, a budget is a predetermined statement of management policy during a givenperiod which provides a standard for comparison with the results actually achieved.Budgetary control is a system of controlling costs which includes the preparation ofbudgets, coordinating the departments and establishing responsibilities, comparingactual performance with that of budgeted and acting upon results to achieve maximumprofitability. Budgeting is essentially concerned with planning, and can be broadlyillustrated by comparison with the routine a ship’s captain follows on each voyage.Operation of Budgetary ControlThe steps involved in a Budgetary Control system can be outlined as follows:
    • 1. Establish a plan or target of performance which coordinates all the activities of the business. 2. Record the actual performance 3. Compare the actual performance with that planned. 4. Calculate the differences, or variances, and analyze use reasons for them. 5. Act immediately, if necessary, to remedy the situation.Objectives of Budgetary ControlBriefly, the main objectives of budgetary control are: 1. To combine the ideas of all levels of management in the preparation of the budget. 2. To coordinate all the activities of the business. 3. To centralize control. 4. To decentralize responsibility to each manager involved. 5. To act as a guide for management decision-making when unforeseeable conditions affect the business. 6. To plan and control income and expenditure so that maximum profitability is achieved. 7. To direct capital expenditure in the most profitable direction. 8. To ensure that sufficient working capital is available for the efficient operation of the business. 9. To provide a yardstick against which results can be compared. 10. To show management where action is needed to remedy a situation.Basic Conditions for the Successful Operation of Budgetary ControlRealistic Budget: The quality of the budget is very important for the successful operationof budgetary control. If should be realistic and operationally feasible. Flexible budget isnormally a good budget as it take into consideration the dynamics of the business. Itmust be based on what is attainable, must suit the organizational facilities andcomplexities and must be flexible to accommodate the changing environment of thebusiness.Qualitative and Timely Reporting : Variances must be analyzed, interpreted and
    • reported in a manner which is easily understandable. Reporting must be on time andbring out significant areas/points and be precise, simple and meaningful. Time is theessence of reporting and maintenance of time schedule enhances the value of reportingand leads to correction of many adverse events/trends which otherwise would havetaken a heavy toll.Management’s Attitude: The management must have a positive attitude towardsbudgetary control. Any scheme of control is a discipline and regulation. Managementmust have faith and confidence in the scheme. Management must take keen interest inthe scheme of budgetary control and render whole-hearted support and cooperation inmaking this a success.Advantages of Budgetary ControlThe following are some of the most significant advantages of budgeting : 1. Budgeting compels management to plan for the future. The budgeting process forces management to look ahead and become more effective and efficient in administering business operations. It instills into managers the habit of evaluating carefully their problems and related variables before making any decisions. 2. Budgeting helps to coordinate, integrate, and balance the efforts of various departments in the light of the overall objectives of the enterprise. This results in goal congruency and harmony among the departments. 3. Budgeting facilitates control by providing definite expectations in the planning phase that can be used as a frame of reference for judging the subsequent performance. Undoubtedly, budgeted performance is a more relevant standard for comparison than past performance is based on historical factors which are constantly changing. 4. Budgeting improves the quality of communication. The enterprise’s objectives, budgets goals, plans, authority and responsibility and procedures to implement plans are clearly written and communicated through budgets to all individuals in the enterprise. This results in better understanding and harmonious relating among mangers and subordinates. 5. Budgeting helps to optimize the use of the firm’s resources, both capital and human. It aids in directing the total efforts of the firm into the most profitable channels. 6. Budgeting increase the morale and thereby the productivity of the employees by seeking their meaningful participation in the formulation of plans and policies, bringing about a harmony between individual goals and the enterprise’s objectives, and by providing incentives for better performance.
    • 7. Budgeting develops profit-mindedness and cost consciousness. 8. Budgeting permits the management to focus attention on significant matters through budgetary reports. Thus, it facilitates management by exception and thereby saves the management’s time and energy. 9. Budgeting measure efficiency and thereby enables self-evaluation by the management, it also indicates the progress made in attaining the enterprise’s objectives.Problems of the Budgeting SystemThe major problems in developing a budgeting system are: 1. Getting the support and involvement of all levels of management. 2. Developing meaningful forecasts and plans, especially the sales plan. 3. Inducing all individuals to get involved in the budgeting process, and gaining their full participation. 4. Establishing realistic objectives, procedures and standards of desired performance. 5. Applying the budgeting systems in a flexible manner. 6. Maintaining effective follow-up procedures, and adapting the budgeting system to changing circumstances.Limitations of Budgetary ControlManagement must consider the following limitations in using the budgeting system as adevice to solve managerial problems: 1. Budgeting is not an exact science, its success depends upon the precision of estimates. Estimates are based on facts and managerial judgement. Managerial judgement can suffer from subjectivity and personal biases. The efficacy of budgeting thus depends upon the quality of managerial judgement. 2. A perfect system of budging cannot be organized in a short period. Business conditions change rapidly. Therefore, the budging system should be continuously adapted to changing circumstance. Budgeting has to be a continuous exercise, it is a dynamic process. Management should not lose patience, it should go on trying various techniques and procedures in developing and using the budgeting system.
    • 3. A skillfully prepared budget system will not by itself improve the management of an enterprise unless it is properly implemented. For the success of the budgetary system, it is essential that it is understood by all, and that the managers and subordinates put in concerted effort for accomplishing the budget goals. All persons in the enterprise must be fully involved in the preparation and execution of budgets, otherwise budgeting will not be effective. 4. Budgeting is a management tool, a way of managing, not the management itself. The presence of a budgetary system should not make management complacent. To get the best results, management should use budgeting with intelligence and foresight, along with other managerial techniques. Budgeting assets management, it cannot replace management. 5. Budgeting will be ineffective and expensive if it is unnecessarily detailed and complicated. A budget should be precise in format and simple to understand, it should be flexible in application. 6. Budgeting will hide inefficiencies instead of revealing them if there is not evaluation system. There should be continuous evaluation of the actual performance. The standards should also be re-examined regularly.Organisation for Budgetary Control 1. Creation of budget centres. Centres of departments should be established for each of which budgets can be set with the help of the head of department concerned. A budget centre is a centre or department or a segment of a an organisation for which budgets are prepared. Budgets should be set with the help of the heads of these centres so that these may be implemented more effectively. 2. Preparation of an organisatoin chart. This defines the functional responsibilities of each member of the management, and ensures that he knows his position in the company and his relationship with other members. 3. Establishment of a budgeted committee. In small companies budget officer or the accountant may coordinate all the work connected with budgets, but in large companies a budget committee is often established to formulate a general programme for preparing budgets and exercising overall control. The Chief Executive of the company may establish guiding principles but usually he delegates the responsibility for operating the system to the budget officer as secretary of the committee. This committee is composed of the chief executive, budget officer and heads of the main department such as those shown in Fig. 1. Each member will prepare his own initial budget or budgets, which will then be considered by the committee, and all budgets will be coordinated. Usually many changes are necessary before the budgets can be finally integrated and approved. 4. Preparation of budget manual. This ia defined (by the I.C.M.A.) as a document
    • which sets out the responsibilities of the persons engaged in the routine of, and the forms and records required for budgetary control. It is usually in loose-leaf form so that alternations can easily be made as and when required, appropriate sections can be issued to executives requiring them. An index will be provided so that information can be located quickly. Such a manual will usually prove invaluable, as it will include information such as: (a) Description of the system and its objectives, (b) Procedure to be adopted in operating system (c) Definitions of responsibilities and duties (d) Reports and statements required for each budget period (e) The accounts code in use. (f) Deadline by which data are to be submitted.5. Budget Period: There is no “right” period for any budget. Budget periods may be short term and long term. If a business experiences seasonal fluctuations, the budget period will probably extend over one seasonal cycle. If this cycle covers, say two or three years, the long-term budget would cover the period, while the short-term budgets would perhaps be preparation on a monthly basis for control purpose. Short-term budgeting is usually costly to prepare and operate, while long-term budgeting may be considerably affected by unforeseen conditions. Budget periods frequently used in industry vary between one month and one year, the latter probably being the most commonly used as it fits in with the normally accepted accounting period. However, forecasts of much longer periods than a year may be used in the case of capital expenditure budgets, for example, which must be planned well in advance. A common practice in industry is to have a series of budget periods. Thus, the sales budget may cover the next five years, while production and cost budgets may cover only one year. These yearly budgets will be broken down into quarterly or even monthly periods. Where long-term budgets are operated it is usual to supplement them with short- term ones.6. The key factor. This is the factor whose influence must first be assessed in order to ensure that functional budgets are reasonably capable of fulfillment. The key factor-known variously as the “limiting” or “governing” or “principle budget” factor is of vital importance. It may not be the same for each budget period, as the circumstances may change. It determines priorities in functional budget. Among the many key factors which may affect budgeting are the following: a. Management i. Lack of capital, restricting policy ii. Lack of knowhow
    • iii. Inefficient executivesiv. Insufficient research into product design and methods.
    • LESSON – 13Classification of BudgetsThough budgets can be classified according to various points of view the followingbases of classification are generally in vogue: (a) Classification according to time factor (b) Functional classification (c) Classification according to flexibility factor. (A) Classification according to time factor. (1) Long-term Budgets (2) Short-term Budgets (3) Current Budgets: They cover a period of a month or so and as shot-term budgets, they get adjusted to prevailing circumstances. Sometimes, within the framework of a short-term budget, there are quarterly plans which are prepared by recasting the budget for a still shorter period on the basis of the performance of the immediate past. In a way, these quarterly budgets are meant to be an elaboration of the annual budget. (B) Functional Classification (1) Sales Budget, (2) Production Budget, (3) Personnel Budget (4) Purchase Budget : Correlated with sales forecast and production planning, it deals with purchases that are required for planned production. purchase would include both direct and indirect materials and goods. (5) Research Budget (6) Cash Budget (7) Capital Budget (8) Master Budget (9) Plant utilization Budget (10) Office and Administration Budget. This budget represents cost of all administrative expenses, such as managing director’s salary, staff salaries and expenses of office management like lighting and cleaning. (C) Classification According to Flexibility (1) Fixed Budget: This is budget in which targets are rigidly fixed. Such budgets are usually prepared from one to three months in advance of the fiscal year to which they are applicable. Thus, twelve months or more may elapse before figures forecast for the December budget Are used to measure actual performance. Many things may happen during this intervening period and they mayh make the figures go widely out of the line with the actual figures.
    • Thought it is true that a fixed, or static budget as it is sometimes called, can be revised whenever the necessity arises, it smacks of rigidity and artificially so far as control over costs and expenses are concerned. Such budgets are preferred only where sales can be forecast with the greatest of accuracy which means, in turn, that the cost and expenses in relation to sales can be quite accurately ascertained.(2) Flexible Budget
    • LESSON – 14SALES BUDGETThis is a forecast of total sales expressed and incorporated in quantities and / or money.A sales budget may be prepared by expressing turnover under any one or combinationof the following: 1. Product or product group; 2. Territories, areas and countries; 3. Types of customers, e.g., National, Government, export, home, wholesales, or retails; 4. Salesman, agents or representatives, and 5. Period; such as quarters, months, weeks, etc.A sales budget may be prepared with the help of any one or more of the followingmethods. (1) Analysis of past sales: Analysis of past sales for a number of years, say 5 to 10 years, viz. long-term trend, seasonal trend, cyclical trend, sundry other factors. The long-term trend represents the movement of the fortunes of a business over many years. The seasonal trend may affect many types of business and hence this factor must be taken into account when studying figures for consecutive months over a number of years. The cyclical trend represents the fluctuations in the business activity due to the effect of the trade cycle. In order to study the cyclical trend it is desirable to disregard the effects to the long-term and seasonal trends. Sundry factors include, such as a strike in the industry or a serious fire or flood. From such analysis it will be possible to suggest future trends. In analyzing such sales, considerable help can be obtained from statistical reports produced by the trade units and commercial intelligence units, government publications, etc. (2) Studying the impact of factors affecting sale: Any change in the company policy or method should always be considered. For example, introduction of special discounts special salesmen, a new design of the product, new or additional advertising campaigns, improved deliveries, after-sales service should have some market effect on a sales budget. While preparing such forecasts, the sales manager must consider the opinion of divisional managers and other sales staff, the budget officer and the accountant. It will be observed that the preparation of a sales budget involves many factors and calls for a high degree of knowledge of conditions, and if ability to deduce fro the known facts and various estimates the
    • probable course of sales budget is prepared first. If production is the key factor, the production budget should be built up first and the sales budget must be drawn up within up within the limits imposed by the production budget.Illustration 1AB Co. Ltd. manufactures two products, A and B, and sells them through two divisions –North and South. For the purpose of submission of sales budget to the budgetcommittee, the following information has been made available. Product North South A 4,000 at Rs. 9 6,000 at Rs. 9 B 3,000 at Rs. 21 45,000 at Rs. 21 Actual sales of the current year were: Product North South A 5,000 at Rs. 9 6,000 at Rs. 9 B 2,000 at Rs. 21 4,000 at Rs. 21Market studies reveal that the product A, is popular but under-period. It is observed thatif the price of A is increased by Re. 1 it will still find a ready market. On the other hand,B is over-period to customers and the market could absorb more if the sales price of Bis reduce by Re. 1. The management has agreed to give effect to the above pricechanges.From the information relating to these price changes and reports from salesman, thefollowing estimates have been prepared by divisional managers. Percentage increase insales over current budget is: Product North South A +10% +5% B +20% +10% Additional sales above the estimated sales of divisional managers are: Product North South A 600 units 700 units’ B 400 units 500 units Prepare a Sales Budget
    • SolutionSales BudgetA B Co. Ltd.For the Year : 19 x 7Prepared by ......................Checked by ......................Submitted on ....................Division Product Budget for Budget for Current Actual sales for Future Period Period Unit Price Current Period Unit Price Value Unit Price Value Value Qty Rs Rs. Qty Rs Rs. Qty Rs Rs. . . .North A 5,000 10 50,000 4,000 9 36,000 5,000 9 45,000 B 4,000 20 80,000 3,000 21 63,000 2,000 21 42,000Total 9,000 1,30,000 7,000 99,000 7,000 87,000South A 7,000 10 70,000 6,000 9 54,000 7,000 9 63,000 B 6,000 20 1,20,000 5,000 21 1,05,000 4,000 21 84,000Total 13,000 1,90,000 11,000 1,59,000 11,000 1,47,000Total A 12,000 10 1,20,000 10,000 9 90,000 12,000 9 1,08,000(Summary) B 10,000 20 2,00,000 8,000 21 1,68,000 6,000 21 1,26,000Total 22,000 3,20,000 18,000 2,58,000 18,000 2,34,000Production BudgetLike the sales budget, the production budget is built up in terms of quantities andmoney. The quantities are entered at the beginning and, when the remainder of thebudget have been built up and the cost of production calculated, the costs are enteredto compile a production cost budget. In preparing the production budget, considerationshould be given to the following: (1) Principal budget factor, e.g., if sales be the budget factor then it should be the
    • sales budget; otherwise other budgets. (2) Production planning and determination of optimum factory capacity. (3) The opening stocks, and stocks required to be carried at the end of the period. (4) The policy of the management regarding manufacture or purchase of components.The production budget may be classified under the following heads: (a) Products (b) Manufacturing department (c) Months, quarters, etc.ABC Col. Ltd.(Production Budget (in units)Items A B For the year..... RemarksSales during the period 12,000 10,000Required stock on 31st Dec. 1,000 2,000Total 13,000 12,000Less Estimated Opening stock 1,000 1,000Estimated production 12,000 11,000Purchase BudgetA purchase Budget gives the details of the purchase which must be made to meet theneeds of the business. It includes all items of purchase. Such as raw materials, indirectmaterials and other equipments. The purchase budget for raw materials is the mostimportant and the following factors are required to be considered in preparing thisbudget. (1) Opening and closing stocks. (2) Unfulfilled orders at the beginning of the budget period. (3) Storage space, economic buying quantity, and financial resources. (4) The prices to be paid.
    • Illustration 5The following information regarding the stocks of materials required for the productionprogramme of Ramesh Limited is available.Materials Estimated Estimated Stocks Consumption (in kg) during 1983-84 (in kg) In 1st July 1983 On 30th June 1984 AB 9,03,000 20,000 17,000 GH 6,90,000 10,000 20,000 XY 5,47,000 30,000 33,000Collating the details given above with the information contained in the Materials Budget,prepare the Purchase Budget of Ramesh Limited.SolutionRamesh LimitedPurchase Budget(1983-84)Particulars AB GH XY kg. kg kgEstimate Consumption 9,03,000 6,90,000 5,47,000Add: Stock required on 30-06-84 17,000 20,000 33,000Total requirements 9,20,000 7,10,000 5,80,000Less: Estimated stock on1st July 1983 20,000 10,000 30,000Quantity to be purchased 9,00,000 7,00,000 5,50,000Price per kg (Estimate Re. 1 50 p 40 pEstimated cost of purchaseof materials (Rs) 9,00,000 3,50,000 2,20,000
    • Preparation of Cash BudgetA complete system of budgetary control makes the construction of cash budget easy. Itis one of the functional budgets which is prepared along with other budgets. There arethree recognized methods of preparing a cash budget. (a) The Receipts and Payment Method; (b) The Adjusted Profit and Loss Method; and (c) The Balance Sheet Method.Steps to be AdoptedCash Receipts Forecast; Cash receipts from sales, debtors, income from sales ofassets and investments and probable borrowings should be forecast and brought intocash budget. Any lag in payment by debtors or by others shall be considered forascertaining further cash inflows.Cash requirements forecast: Total cash outflows are taken out from operating budgetsfor the elements of cost, and from capital expenditure budget for the purchase of fixedassets. Adjustments are to be made for any lag in payments.Care must be taken to ensure that outstanding or accruals are excluded from the cashbudget since this method is based on the concept of actual cash flows.Illustration 6A newly started company Quick Co. Ltd., wishes to prepare cash budget from January.Prepare a cash budget for the first six months from the following estimated revenue andexpenditure.
    • Month Total Sales Material Wages Production Selling and Overheads distribution Overheads Rs. Rs. Rs. Rs. Rs.,Jan. 20,000 20,000 4,000 3,200 800Feb. 22,000 14,000 4,400 3,300 900Mar. 24,000 14,000 4,600 3,300 800Apr. 26,000 12,000 4,600 3,400 900May. 28,000 12,000 4,800 3,500 900June 30,000 16,000 4,800 3,600 1,000Cash balance on 1st January was Rs. 10,000. A new machine is to be installed at Rs.30,000 on credit, to be repaid by two equal installments in March and April.Sales commission @ 5% on total sales is to be paid within the month following actualsales. Rs. 10,000 being the amount of 2nd call may be received in March. Sharepremium amounting to Rs. 2,000 is also obtainable with 2nd call.Period of credit allowed to suppliers 2 monthsPeriod of credit allowed to customers 1 monthDelay in payment of overheads 1 monthDelay in payment of wages ½ monthAssume cash sales to be 50% of total sales.
    • Quick Co. Limited Cash Budget For the period January to June 1984Details Jan. Feb. Mar. Apr. May. June Rs. Rs. Rs, Rs, Rs, Rs.A Balance b/d 10,000 18,000 29,000 20,000 6,100 8,800B Receipts: 10,000 11,000 12,000 13,000 14,000 15,000Cash Sales (50%)Debtors - 10,000 11,000 12,000 13,000 14,000Capital - - 10,000 - - -Share premium - - 2,000 - - -(A + B) Total 20,000 39,000 64,800 45,000 33,100 37,800C Payments Material - - 20,000 14,000 14,000 12,000Wages 2,000 4,200 4,500 4,600 4,700 4,800Production Overheads - 800 900 800 900 900Commission - 1,000 1,100 1,200 1,300 1,400Machinery - - 15,000 15,000 - -(C) Total 2,000 9,200 44,800 38,900 24,300 22,600Balance(A+B+C) 18,000 29,800 20,000 6,100 8,800 15,200Flexible BudgetsIn those industries where the pattern of demand is stable, a fixed budget may beadequate, especially where the budget period is comparatively short. In suchbusinesses it is possible to forecast sales with a considerable degree of accuracy.There are many undertakings where stable conditions are absent. In such concernsfluctuations in output might lead to violent deviations fromd the budget. In suchconcerns it is usual to adopt the flexible budgetary technique. A flexible budget is abudget which is designed to change in accordance with the level of activity actuallyattained. If flexible.The owner of a car knows that the more he uses it per year the more it costs him to
    • operate it. He also knows that the more he uses his car the less its costs per runningmetres. The reason for this lies in the nature of the expenses, some of which are fixedwhile others are variable or semivariable. Insurance, taxes, registration, and garagingare fixed costs; they remain the same whether the car is operated 1,000 or 2,000kilometers. The costs of tyres, petrol oil, and repair are variable costs and dependlargely upon the kilometers driven. Obsolescence and depreciation result in a combinedtype of cost that, although fluctuating to some degree upon the usage of the car, issemi-variable for it does not vary directly with the usage. The cost of operating the carper kilometer depends on the number of kilometers the car is used. The mileageconstitutes the basis for judging the activity of the automobile. If the owners prepares anestimate of total cross and compares his actual expanses with the budget in keeping hisexpenses within the allowed limits, unless he takes the mileage factor into account.Originally, the flexible budget idea was applied principally to the control of departmentalfactory overhead. In recent years, however, the idea has been applied to the entirebudget so that production budgets as well as selling and administrative budgets areprepared on a flexible basis. The construction of a flexible budget is identical with that ofa fixed budget, except that a budget is calculated for each volume ranging from apossible 60 per cent to 100 per cent of capacity. When actual figures are availableestimate previously determined for the level attained are compared with actual results,and the differences are noted. This end-of period comparison is used to measure theperformance of each department head. It is this readymade method of comparison thatmakes the flexible budget a valuable instrument for cost control. The flexible budgetassists in evaluating the effects of varying volumes of activity on profits and on cashposition.Illustration 9The following data are available in a manufacturing company for the half-year periodending 30th June, 1984.Fixed expenses: Rs. (Lakhs)Wages and salaries 8.4Rent, rates, and taxes 5.6Depreciation 7.0Sundry administrative expenses 8.9 29.9
    • Semi-variable expenses @ 50% ofcapacity -Maintenance and repairs 2.5Indirect labour 9.9Sales department salaries etc., 2.9Sundry administrative expenses 2.6 17.9Variable expenses: @ 50% of capacity -Material 24.0Labour 25.6Other expenses 3.8 53.4It is assumed that fixed expenses remain constant for all levels of production’ semi-variable expenses remain constant between 45% and 65% of capacity, increasing by10% between 65% and 80% of capacity and 20% between 89% and 100% of capacity.Sales at the various levels are: 60% capacity Rs. 100.00 lakhs 75% Capacity 120.00 Lakhs 90% Capacity 150.00 Lakhs 100% Capacity 170.00 LakhsPrepare a flexible budget for the half-year and forecast the profits at 60%, 75%, 90% ofcapacity.
    • SolutionFlexible Budget for the Half-Year Ending 30th June 1984(showing the forecast of profit of different levels) Operating capacityElements of cost 50% 60% 75% 90% 100% StandardA Fixed expenses:Wages and salaries 8.4 8.4 8.4 8.4 8.4Rent, rates and taxes 5.6 5.6 5.6 5.6 5.6Depreciation 7.0 7.0 7.0 7.0 7.0Sundry expenses 8.9 8.9 8.9 8.9 8.9 29.9 29.9 29.9 29.9 29.9B. Semi-variable exp:Maintenance and repairs 2.5 2.5 2.75 3.00 3.00Indirect labour 9.9 9.9 10.89 11.88 11.88Sales Dept. salaries 2.9 2.9 3.19 3.48 3.48Sundry Adm. expenses 2.6 2.6 2.86 3.12 3.12 17.9 17.9 19.69 21.48 21.48C. Variable expenses:Material 24.0 28.80 36.00 43.20 48.0Labour 25.6 30.72 30.47 46.08 51.2
    • Other expenses 3.8 4.56 5.70 6.84 7.6 53.4 64.08 80.17 96.12 106.8Total cost of Production 101.2 111.88 129.76 147.50 158.18(i.e. Total of A, B and C) Profit -11.88 -9.76 +2.50 +11.82(+) of Loss (-)Sales 100.00 120.00 150.00 170.00Less: Bills Payable = 10,000Sundry Creditors = Rs. 1,91,667
    • LESSON – 15 CAPITAL BUDGETINGConcept of Capital ExpenditureEvery business concern has to face the problem on capital expenditure decisions sometime or the other. Hence, planning for capital expenditure has become an integral part ofpolicy making, management and budgetary control. Capital expenditure is one which isintended to benefit future periods and normally includes investment in fixed assets andother development projects. It is essentially a long-term function, and such for adecision to buy land, buildings or plant and machinery etc., would influence the activityof the business for a considerable period of time. Hence, it is essential to keep a closewatch on capital expenditure at all times. Further, the advent of mechanization andautomation has resulted in management being confronted with ever more frequent anddifficult problems. Despite the fact that various techniques have been developed toassist management in its task of decision-making more effectively, the ultimate decisiondepends on the availability of relevant information which can be generated only by well-established capital expenditure budgeting system. The other commonly usednomenclatures for capital expenditure decision are “Capital Budgeting”, or “Capitalinvestment Decision”, or simply “Investment Decisions”.Concept of capital BudgetingCapital budgeting normally refers to long-term planning for proposed capital outlays andtheir financing. It is the decision-making process by which firms evaluate the acquisitionof major fixed assets whose benefits would be spread over several time periods.Succinctly, it involves current investment in which the benefits are expected to bereceived beyond one year in the future. The use of one year as a line of demarcation is,however, somewhat arbitrary. The main exercise in capital budgeting is to judgewhether or not an investment proposals provides a reasonable return to investors whichwould be consistent with the investment objective of the business. Hence, capitalbudgeting involves generation of investment proposals, estimating costs and benefits(cash flows) for the investment proposals and evaluation of net benefits and selectionof projects based upon an acceptance criterion.Importance of Capital Budgeting
    • 1. Involves commitment of huge financial resourcesThe capital investment involved is usually very large. It will have several far-reachingimplications on the activities of business and may even seriously affect the veryfinancial or flexibility of the business. It is these implications which make capitalbudgeting so important. 2. Wrong sale forecast may lead to over-or under-investment of resourcesIt shows the possibility of expanding the production facilities to cover additional salesshown in the sales forecast. In fact the economic life of the asset acquired representsan indirect sales forecast for the duration of its economic life. Any error in this regordmay result in over-or under-investment in fixed assets, i.e., excess production capacityor inadequate capacity. It also enables the cash forecast to be completed. 3. Leads to better timing of assetsCapital budgeting may allow altimative forms of assets to be considered as replacementfor assets which are wearing out or are in danger of becoming obsolete in other words,it would lead to better timing of asset purchases and improvement in quality of assetspurchased. It helps to match efficiently the need for capital goods with their availability.It also assists in formulating a sound depreciation and asset replacement policy. 4. It ensures the selection of the right source of finance at the right time.Capital expenditure decisions involve substantial funds which may not be immediately,and automatically available. A well – established capital budget would enable themanagement to decide in advance the source of finance and ensure their availability atthe right time.Objective of capital Budgeting 1. Selection of the right mix of profitable projects.It may be said that the overall objectives of capital budgeting is to allocate the availableinvestible funds among the competing capital projects in order to maximize the totalprofitability. This is made possible by employing the various evaluation techniques forthe selection of investment projects which contribute the maximum towards the overallinvestment objective. In the case of public enterprises, capital budgeting may alsoassure fulfillment of other objective such as promotion of employment, development ofbackward regions, etc.
    • 2. Capital Expenditure control.Control of capital expenditure is the next important objective of capital budgeting. This isachieved by forecasting the long-term financial requirements and thereby enabling themanagement to plan in advance to raise funds at the right time. The objective ofpreparing capital budget is to plan and then compare the actual capital expenditure withthe budgeted figure for controlling costs. 3. Determining the required quantum and the right source of funds for investment.The next important objective of capital budgeting is to determine the funds required forlong-term project and to see that such estimates fall in line with the company’s financialpolicies. It also aims to compromise between the availability of funds and needs of thecapital projects.Types of capital investment projectsInvestment projects may be classified in a number of ways. The following kinds ofinvestment projects are commonly used by both private and public sector business unitsin their capital expenditure forecasts: (a) Expansion of existing product lines. (b) Expansion into new product lines. (c) Replacement and modernization schemes (d) Projects for the utilization of scraps, and also of surplus installed capacity (e) Cost reduction projects.The projects listed above are generally profit-oriented and therefore they may beevaluated on the basis of their costs and benefits. But there are investments which areundertaken by all business units and on which it would be difficult to measure returns,such as the following: (1) Safty precautions provision of safety devices and equipment may be demanded by various legal requirements. (2) Welfare projects: provision of sports facilities for employees may boost employees morale. This cannot be evaluated financially. (3) Service projects: provision of buildings and equipment for non manufacturing departments may be essential, but the return from investment on them cannot be evaluated.
    • (4) Research and development: This may be initiated to improve the company methods or products. It would be very difficult to measure the return on R&D for a considerable period of time. (5) Educational projects: Provision of company training course may be instrumental in improving the efficiency of employment but the returns from investment on such programmes may be difficult to evaluate.Relevant cost for capital expenditure decisionGenerally, costs and benefits in the form of cash flows are more relevant for capitalbudgeting then the conventional accounting cost and benefits because such costs andbenefits normally encounter a number of measurement problems owing the factors suchas method of depreciation, valuation of inventories, write-off etc., Different types ofinvestment decisions call for different kinds of costs. not all costs which are used inconventional accounting system are relevant for investment decision making. A fewitems of relevant costs are:Future costs: Future costs are the projected or estimated costs. they are relevant for alltypes of investment decision past cost, though not relevant for decision-making, areuseful to the extent that they furnish a starting point for future cost projections. Whilecalculating these costs, factors such as market conditions, economic conditions, politicalsituation, general trend in the price levels, probabilities relating to future production andsales, economic life of the project, etc. are to be taken into account.Opportunity costs: In simple terms, opportunity cost refers to the benefits of the bestalternative foregone. As the investment in a project involves commitment of the firm’sinvestible funds it becomes relevant to consider the opportunity of getting some benefitsby employing the resources on some other alternative. For example, in an expansionscheme the economic value of the space required rather than its book value is relevant.In a replacement decision, the realizable value rather then the book value of the oldmay be relevant as a reduction of the cost of replacement. This type of cost is relevantfor all types of investment decision. Imputed cost is a kind of opportunity cost. It is thecost which is not actually incurred, but would be incurred in the absence of self-ownedfactors, e.g. cost of retained earnings, rent on company owned facilities, etc.Incremental or differential cost: It is the additional cost due to a change in the volume ofbusiness or nature of business activity. Hence it is useful for decisions such as addingnew machinery, new – product, changing a distribution channel etc. sometimes this costis considered synonymous with marginal cost. But marginal cost has much limitedmeaning as it refers to the cost of an added unit of output.Interest cost : Accounting reports normally ignore the imputed interest on capital which
    • is relevant for decision-making purposes. Interest cost constitutes the minimumacceptance criterion for capital investment projects undertaken for profit. A firm must atleast recover its money before it can realize a profit on its own investment.Depreciation and Income-tax: Depreciation is normally excluded while calculating cashflows for investment, appraisal and evaluation. But it is included for calculating theaccounting rate of the project. Payment of taxes results in cash flows and therefore, isan important element in capital investment decisions. Income-tax has a number ofeffects on capital investment decisions. Hence, tax laws and applicable legal decisionsemphasise the need for special skill in this area.Secondary costs and benefits: These costs and benefits are particularly relevant for thecapital expenditure decision in public enterprises. They are external to the projectimplementing body and there for called external cost and benefits, or simply“externalities”. These are the costs and benefits, which are imposed on other sectors-government, society or the economy as a whole – during the construction and operationof the project and for which nothing is paid or received. There are two types ofexternalities, viz., technological and pecuniary. The smoke and dust pollution and noiseetc., are examples of technological externalities pecuniary externalities are such asincreasing rates of hire for factors of production, reduction in prices of substituteprojects, etc. secondary benefits are the increase in profits that can be attributed to theincreased activity of processors, merchants and others who handle the project’s outputor input. The major problems associated with these costs and benefits are theiridentification and measurement. However, for easy identification they should be relatedto the socioeconomic objectives assigned to the project. To measure these costs andbenefits, shadow prices or imputed prices should be used.Capital Expenditure ControlThe control over capital expenditure is growing in importance as mechanization andautomation are introduced and extended. However, formal capital budgeting is stillundeveloped as it is of comparatively recent origin. Any system of capital expenditurecontrol should have the following feature.Planned development: Capital expenditure should be carefully planned to includedevelopments in each site or department to ensure that each unit in the group orcompany is developing in step with the overall plan preparation of capital budget will beessential, even when companies to not operate a complete system of budgetary control.Capital appropriations and payment must be planned well in advance.Control of progress: A progress record is necessary to show the progress of each
    • capital project. The budget and actual expenditure will be compared for analysis andcontrol. These reports are also useful to ensure that the overall programme remainswithin the limits set by the policy of the company.Post-completion Audits: This is an important step of capital expenditure control. Post –completion audits of projects determine. Where their actual value is in accordance withthe one determined at the time of authorization. This review can be very importantbecause it may reveal inefficiencies in the system, and it would provide experiencewhich would help in avoiding repetition of mistakes.Forms and procedures: There should be a routine for controlling capital expenditure. Aprocedure should be adopted for the various stages requesting for capital expenditures,authorization, reporting the progress of such projects and audit. A well designed fromshould be used for the above purposes for better control.
    • LESSON – 16Methods of Ranking Investment ProposalsThe final step in a the capital budgeting system involves evaluating the profitability ofthe alternative project and selecting the best one. A firm may face a situation wheremore investment proposals may be available than investible funds. Some proposalsmay be good, some moderate, and many poor. Hence, a ranking procedure has to beevolved so that the available funds can be allocated among different proposals in aprofitable manner. Essentially, the ranking procedure envisages relating of a stream offuture benefits to the cost of investments. Among the various methods, the following arecommonly used by many business concerns:Traditional or non-time value techniques i. Payback period ii. Average rate of return iii. Modern or time value techniques iv. Discounted cash flow methods v. Net present value vi. Benefit / cost radiovii. Internal rate of returnPayback periodBusiness units, while selecting investment projects, would consider the recover of costas the first and foremost concern, even though earning maximum profit is then ultimategoal. Payback period normally refers to the time required for recouping the initialinvestment in full with the help of the stream of annual cash flows generated by theproject. It is also called ‘pay-out or pay off period”, expressed, as: C Payback period (PB) = ------------ 1Where C = original coast of investment, and I = annual cash inflows.In the case of uneven cash inflows it may be expressed as
    • PB = P = ∑Where X represents cash flows during periods 0,1,2,.....P represents payback period.The cash flows for the purpose of PB calculation, would be savings or earnings afterpayment of taxes but before depreciation. To illustrate, if a cash outlay of Rs. 30,000 isexpected to yield a constant net cash flow (cash earnings minus cash expenses) of Rs.12,000 P a for a period of 5 years, the PB is 2 ½ years (Rs. 30,000 + Rs. 12,000).Selection criteria: Among the mutually exclusive or alternative projects whose PBs arelower than the cut-off period, the project with the shorter PB would be selected. In casethere are budget constraints, the procedure would be to rank the projects in theascending order of PBs and select the first ‘X’ number of projects which the budgetprovision permit. However, with a views to making the selection process more realistic,a cut-off period or minimum payback ratio could be set up and all investment proposalsfor which the PB is greater than this cut-off period be rejected. Payback ratio is theinverse of the payback period. For a payback period of 4 years, the payback ratio is1/4. Thus larger the payback ratio, better the project.Illustration 1From the following advise the management as to which project is preferable based onpayback period. The standard cut off period for the company is 5 years. Project A Project B Rs. Rs. Capital cost 15,000 15,000Cash flows (savings before depreciation, but after taxes) Ist year 5,000 4,000 IInd year 5,000 4,000 IIIrd year 5,000 4,000 IVth year 2,000 3,000 Vth year 2,000 7,000 VIth year 2,000 9,000 21,000 31,000
    • Solution Project A Project BPayback period = 3 years 4 years (5,000 + 5,000 + 5,000 = 15,000) (Rs. 4,000 + 4,000 + 4,000 + 3,000 = 15,000)The PBs of A and B are 3 years and 4 years respectively and thus project. A isadjudged superior to project B in terms of PB criterion since it is also shorter than thecut-off period.Merits of payback period: 1. It is easy to operate and simple to understand 2. This method is preferred on the ground that returns beyond three or four years are so uncertain that it is better to disregard them altogether in a planning decision. 3. It is appropriate for industries with a high rate of technological obsolescence in which the receipts beyond PB are regarded as totally uncertain. 4. This method is also useful to a concern which is short of cash and is eager to get back the cash invested in a capital expenditure project. 5. As the method considers the cash flows during the payback period of the project, the estimates would be reliable and the results may be comparatively more accurate.Despite the simplicity and ease of operation, this method suffers from severaldrawbacks.Demerits 1. The PB is more a liquidity than a profitability concept, for it places accent only on the recovery of cash outlay and stresses the importance of liquidity, that is recovery at the cost of profitability. 2. It does not consider the earnings beyond the payback period. This may lead to wrong selection of investment projects. Profitable projects with long gestation periods or projects which generate high returns only after a certain period of time may be rejected under this method. 3. The most serious limitation of this method is that it ignores the time value of money.
    • Average Rate of return Method (ARR)ARR is considered to be an improvement over the PB method for it considers theearnings of a project during its entire economic life. It is also known as ‘Return oninvestment method’. Average earnings or return ARR = -------------------------------------------------- x 100 Average investmentThe average return is computed by adding all the earnings after depreciation, anddividing them by the project’s economic life. Average investment is the simple averageof the values of assets at the beginning and end of the useful life of the asset which inmost cases, Would be zero. Though sometimes initial investment is used, averageinvestment is more logical.Selection Criteria: The decision rule is that a project with the highest rate of return oninvestment is selected on condition that such rate is above the standard rate set, or thecut-off rate.Illustration 2Calculate the average rate of return for project ‘A’ and ‘B’ from the following information. Project A Project B Invested (Rs) 25,000 37,500 Expected life (in years) 4 5 Net earnings (after depreciation and taxes) Years 1 2,500 3,750 2 1,875 3,750 3 1,875 2,500 4 1,250 1,250 5 -- 1,250 7,500 12,500If the desired rate of return is 12%, which project should be selected?
    • Solution Project A Project BAverage return Rs. 7,500 Rs. 12,500 4 5 -Rs. 1,875 Rs. 2,500Average investment Rs. 25,000 + 0 Rs. 37,500+0 2 2 -Rs. 12,500 Rs. 18,750Average rate of Rs. 1,875x100 Rs. 2,500x100 Rs. 12,500 Rs. 18,750return -15% 13.33%Both the projects satisfy the minimum required rate of return. However, if the projectsare mutually exclusive or alternative i.e. only one project is to be selected, project A willbe selected as its ARR is higher than project B. if they are not mutually exclusive, andthere are no budget constraints, both the projects will be selected.Merits: 1. This method is also easy to understand and simple to operate 2. The ARR method takes into account earnings over the entire economic life of the project. 3. This is really a profitability concept since it considers net earnings after depreciation, i.e., excess of earnings over original cost of investment. 4. Projects which differ widely in characted could be compared under this system.Demerits 1. The most severe criticism of this method is that it ignores the time value of
    • money.2. Normally, a host of variants are to be resolved relating to its components viz., earnings and investment cost. For example, it may be the gross, net or average investment which is to be considered for computation. This may produce different rates of any one proposal.3. Another problem in connection with the method is regarding a reasonable rate of return on investments. Some stipulate a minimum rate so that if projects do not satisfy this rate, they are summarily excluded from consideration.
    • LESSON – 17Discounted Cash Flow (DCF) Method or Time Adjusted TechniqueThe discounted cash flow technique is an improvement on the pay-back period method.It takes into account both the interest factor as well as the return after the pay-backperiod. The method involves three stages. i. Calculation of cash flows, i.e., both inflows and outflows (preferably after tax) over the full life of the asset. ii. Discounting the cash flows so calculated by a discount factor iii. Aggregating of discounted cash inflows and comparing the total with the discounted cash outflows. iv. Discounted cash flow technique thus recognizes that Re 1 of today (the cash outflow) is worth more than Re. 1 received at a future date (cash inflow)Discounted cash floe methods for evaluating capital investment proposals are of threetypes: (a) Net Present Value (NPV) Method (b) Excess Present value Index (or) Benefit Cost Ratio (c) Internal Rate of ReturnNPV MethodThis is generally considered to be the best method for evaluating the capital investmentproposals. In case of this method cash inflows and cash outflows associated with eachproject are first worked out. The present values of these cash inflows and outflows arethen calculated at the rate of return acceptable to the management. This rate of return isconsidered as the cut-off rate and is generally determined on the basis of cost of capitalsuitably adjusted to allow for the risk element involved in the project. Cash outflowsrepresent the investment and commitments of cash in the project at various points oftime. The working capital is taken as a cash outflow in the year the project startscommercial production. profit after tax but before depreciation represents cash inflow.The Net present value (NPV) is the difference between the total present value of futurecash inflows and the total present value of future cash outflows.
    • The equation for calculation NPV is case of conventional cash flows can be put asfollows: R1 R2 R3 Rn NPV = ------ + ------- + -------- + --------- (1 + k) (1 + k)2 (1 + k)3 (1 + k)nIncase of non-convential cash inflow (i.e. where there are a series of cash inflows aswell cash outflows ) the equation for calculating NPV is as follows: R1 R2 R3 Rn NPV = ------ + ------- + -------- + --------- (1 + k) (1 + k)2 (1 + k)3 (1 + k)n 11 12 13 1n 10 ------ + ------- + -------- + --------- (1 + k) (1 + k)2 (1 + k)3 (1 + k)nWhere NPV = Net present value, R = Cash Inflows at different time periods, K Cost ofCapital or Cut-off Rate, 1 = Cash outflows at different time periods.Accept or reject criterion. The net present value can be used as an accept or reject’criterion. In cash the NPV is positive (i.e., present value of the cash inflows is more thanpresent value of cash outflows) the project should be accepted.IllustrationThe Alpha Co. Ltd. is concidering the purchase of a new machine. The alternativemachines (A and B) have been suggested, each having an initial cost of Rs. 4,00,000and requiring Rs. 20,000 as additional working capital at the end of 1 st year. Earningafter taxation are expected to be as follows:
    • Cash Inflows Year Machine A Machine B 1 40,000 1,20,000 2 1,20,000 1,60,000 3 1,60,000 2,00,000 4 2,40,000 1,20,000 5 1,60,000 80,000The company has a target of return of 10% and on this basis, you are required tocompare the profitability of the machines and state which alternative you considerfinancially preferable.Note: The following table gives the present value of Re.1 due in ‘n’ number of years. Year Present value at 10% 1 0.91 2 0.83 3 0.75 4 0.68 5 0.62
    • Solution The Alpha Company STATEMENT SHOWING THE PROFITABILITY OF THE TWO MACHINESYear Discount Machine A Machine B Cash Inflow Present Cash Inflow Present Value value Rs. Rs. Rs. Rs.1 0.91 40,000 36,000 1,20,000 1,09,2002 0.83 1,20,000 99,600 1,60,000 1,32,8003 0.75 1,60,000 1,20,000 2,00,000 1,50,0004 0.68 2,40,000 1,63,000 1,20,000 81,6005 0.62 1,60,000 9,200 80,000 49,600Total present value of cash inflow 5,18,400 5,23,200Total present value of cash outflow 4,18,200 4,18,200(Rs. 4,00,000 + 20,000 x 91)Net present Value 1,00,200 1,05,000Excess Present value Index : This is a refinement of the net present value method.Instead of working out the net present value, a present value index is found out bycomparing the total of present value of future cash inflows and the total of the presentvalue of future cash outflows. This can be put in the form of following formula.Excess Present Value Index. Present value of future cash inflows(Or) Benefits Cost (B/C) Ratio = ---------------------------------------------------------------- x 100 Present value of future cash outflowsExcess present value Index provides ready comparison between investment proposalsof different magnitudes. For example, ‘A’ requiring an investment of Rs. 1,00,000 showsexcess present value of Rs. 20,000 while another project ‘B’ requiring an investment ofRs. 10,000 shows an excess on present value of Rs. 5,000. If absolute figures ofpresent values are compared, Project ‘A’ may to be profitable.
    • However, if excess present value index method is followed project ‘B’ would prov e tobe profitable. 1,20,000 Present Value Index for project A = ------------------------ x 100 = 120% 1,00,000 15,000 Present Value Index for Project B = ------------------------- x 100 = 150% 10,000
    • LESSON – 18 INTERNAL RATE OF RETURNInternal Rate of Return is that rate at which the sum of discounted cash inflows equalsthe sum of discounted cash outflows. In other words, it is the rate which discounts thecash flows to zero. It can be stated in the form of a ratio as follows: Cash Inflows ------------------- = 1 Cash outflowsThus, in case of this method the discount rate is not known but the cash outflows andcash inflows are known. For example, if a sum of Rs. 800 invested in a project becomesRs. 1,000 at the end of a year, the rate of return comes to 25% calculated as follows: R 1 = ------------- 1+rWhere I = Cash Outflow, i.e., initial Investment R = Cash Inflow r = Rate of return yoclded by the Investment (or IRR)Thus: 1000 800 = ---------- 1+rOr 800r + 800 = 1,000Or 800r = 200
    • 200 Or r = ------------------ 25 or 25% 800Illustration Cost of project Rs. 11,000 Cash inflow: Year 1 6,000 Year 2 2,000 Year 3 1,000 Year 4 5,000Find out Internal Rate of ReturnSolution: I F = -------------------- C F= Factor to be located I= Original investment C= Average cash inflow per yearThe ‘factor’ would be 11,000 F = -------------------- = 3.14 3,500The factor thus calculated will be located in. Table II on the line representing number ofyears corresponding to estimated useful life of the asset. This would give the estimate
    • date of return to be applied for discounting the cash inflows for the internal rate ofreturn. The rate comes to 10%. Year Cash inflow Discounting Factor Present value at 10% 1 6,000 0.909 5,454 2 2,000 0.826 1,652 3 1,000 0.751 751 4 5,000 0.683 3,415 Total present value 11,272The present value at 10% comes to Rs. 272. The initial investment is Rs. 11,000.Internal rate of Return may be taken approximately at 10%In case more exactness is required another trial rate which is slightly higher than 10%(since at this rate the present value is more than initial investment) may be taken.Taking a rate of 12%, the following results would emerge. Year Cash inflow Discounting Factor Present value at 10% 1 6,000 0.893 5,358 2 2,000 0.797 1,594 3 1,000 0.712 712 4 5,000 0.636 3,180 Total present value 10844The internal rate of return is this more than 10% but less than 12%. The exact rate maybe calculated as follows:
    • Difference in calculated Present value and required net cash only Internal Rate of Return = ------------------------------------------- x Difference in rate Difference in calculated present values 11,272 - 11,000 = 10% + -------------------------------- x 2 11,272 – 10,844 272 = 10% + ------------- x 2 = 11.3% 428The exact internal rate of return can be also calculated as follows:At 10% the present value is + 272At 12% the present value is – 156.The internal rate would, therefore, the between 10% and 12% calculated as follows: 272 = 10 + --------------------- x 2 272 + 156 = 10 + 1.3 = 11.3%Merits: The merits of discount cash flow method are as follows: (i) Discounted cash flow technique take into account the time value of money conceptually it is better than other techniques such as pay-back or accounting rate of return.
    • (ii) The method takes into account directly the amount of expenses and revenues over the project’s life. In case of other methods simply their averages are taken.(iii) The method automatically gives more weight to those money value which are nearer to the present period than those which are father from it. While in case of other methods, all money units are given the same weight which seems to be unrealistic.(iv) The method makes possible comparison of projects requiring different capital outlays, having different lives and different timings of cash flows, at a particular moment of time because of discounting of all cash flows.Demerits: The following are the demerits of discounted cash flow method.(1) The method is difficult to understand and work out as compared to other method of ranking capital investment proposals.(2) The method takes into account only the cash inflows on account of a capital investment decision. As a matter of fact, the profitability or other wise of a capital proposal can be judged. Only when the net income (and not the cash inflow) on account of operations is considered.(3) The method is based on the presumption that cash inflow can be invested at the discounting rate in the new projects. However, this presumption does not always hold goods because it all depends upon the available investment opportunities.
    • LESSON – 19 MARGINAL COSTING AND COST VOLUME PROFIT ANALYSISMarginal costing is a technique of ascertaining marginal costs or variable costs. it is nota system for cost ascertainment, but is mainly a technique to deal with the effect onprofits of changes in volume or type of output. This technique may be used inconjunction with other methods of costing. Marginal costing is also known as ‘directcosting’ or ‘variable costing’. The latter expressions are mainly used in the UnitedStates.Concept of Marginal Cost and Marginal CostingThe concept of ‘marginal cost’ has been borrowed from economic theory. To theeconomist, marginal cost is an incremental cost: he considers it as the addition to totalcost which results from the production of one more unit of output. That is, it does notarise if the additional unit is not produced.The Institute of Costs and Management Accountants, London, defines marginal cost as:“The amount at any given volume of output by which aggregate cost are changed if thevolume of output is increased or decreased by one unit.” As referred to here, a unit mayindicate a single article, a batch of articles, an order a stage of production capacity, aprocessor a department, i.e., it relates to the change in output in the particularcircumstances under consideration.Under marginal costing, costs are mainly classified into fixed costs and variable costs.the essential feature of marginal costing is that the product or marginal costs (i.e., thosecosts which are dependent on the volume of activity, are separated from the period orfixed costs, i.e., costs which remain unchanged with a change in the volume of activity.Variability with the volume of output is the main criterion for the classification of costsinto product and period categories. Even the semi-variable costs have to be bifurcatedinto their fixed and variable components based on the variability criterion. In this regard,the absorption or conventional costing system differs from marginal costing. Underabsorption costing system all manufacturing costs, whether of fixed or variable natureare treated as product costs. all companies which use marginal costing as an aid tomanagerial decision-making mainly use the absorption costing system.
    • PROFORMA MARGINAL COST STATEMENT Product X Product Y TotalSales ................ ................ ...................Less: Variable cost ................ ................ ...................Contribution ................ ................ ...................Less fixed cost ................... profit --------------From the marginal cost statement, the following equations may be derived:Contribution = Sales – Variable costContribution = Fixed cost + profitFixed cost = Contribution – profitFixed cost = Contribution + LossContribution = fixed Cost + LossSales = Variable cost + ContributionVariable cost = Sales – contributionProfit = Contribution – fixed costLoss = fixed cost – contributionThese equations may be used for solving problems of different types involving cost-volume – profit relationship.The Concept of Contribution and its SignificanceContribution is the difference net sales and marginal costs, and it is used to recoverfixed costs first. Any excess over fixed costs would be profits. When a businessmanufacturers more than one product, the computation of profits realized on individualproducts may be difficult due to the problem of apportionment of fixed costs to differentproducts., the rationale of contribution lies in the fact that fixed costs are done away with
    • under marginal costing. The concept of contribution helps to determine the breakevenpoints, profitability of products, departments, etc., to select product-mix for profitmaximization, and to fix selling prices under different circumstances such as tradedepression, expert sales prices discrimination etc. contribution is the definite test toascertain whether a product or process is worthwhile to continue among differentproducts or processes.Problem of Key Factor, or Measurement of ProfitabilityThe contribution could be used as a measure to solve the problem of key factor. A keyfactor, otherwise called ‘limiting factor’, or ‘principal budget factor’, or ‘scarce factor’,may be defined as the factor which, over a period, will limite the volume of output, orwhich puts a limit on the efforts of the management to produce as many units of theselected products as it would like to when manufacture and sale of a product areconfronted by the problem of key factor, the profitability of that particular product is thenascertained by relating the key factor used for the manufacture of the product, and itsresulting contribution. Generally, sales would be the limiting factor but sometimes,materials, labour, plant capacity, etc., may be the inhibiting, factor when the key factorand contribution are given, the relative profitability may be calculated by employing theformula given below: ContributionProfitability = ------------------------ Key factorFor example, when material is in short supply, profitability is determined by dividing thecontribution per unit by the quantity of materials used per unity when sales is the keyfactor, profitability is measured by contribution sales ratio, and so on.Advantages of Marginal Costing (a) Marginal costing is easy to understand. It can be combined with standard costing and budgetary control and thereby make the control mechanism more effective. (b) Elimination of fixed overhead from the cost of production prevents the effect of varying charges per unit, and also prevents the carrying forward of a portion of the fixed overheads of the current period to the subsequent period. As such cost and profit are not initiated and cost comparisons becomes more meaningful. (c) The problem of over or under absorption of overheads is avoided. (d) A clear-cut division of costs into fixed and variable elements makes the flexible
    • budgetary control system more easy and effective and thereby facilitated greater particle cost control. (e) If helps profit planning through break – even charts and profit graphs comparative profitability can easily be assessed and brought to the notice of the management for decision-making. (f) It is an effective tool for determining efficient sales or production policies, or for taking pricing and tendering decisions, particularly when the business is at a low ebb. Managerial Uses of Managerial Costing: From the advantages stated above, the following may be listed as specific managerial uses: (a) Cost Ascertainment: Marginal costing technique facilitates not only the recording of costs but their reporting also. The classification of costs into fixed and variable components makes the top of cost ascertainment more easy. The main problem in this regard is only segregation of the semi-variable cost into fixed and variable elements. However, this may be overcome by adopting any of the methods already explained for the purpose. (b) Cost control: Marginal cost statements can be understood more easily by the management than those presented under absorption costing bifurcation of costs into fixed and variable enables management to exercise control over production cost and thereby effect efficiency. In fact, while variable costs are controllable at the lower levels of management, fixed costs can be controlled at the top level. Under this technique management can study the behaviour of costs at varying conditions of output and sales and thereby exercise better control over costs.Limitations of Marginal costingDespite its superiority over absorption costing, the marginal costing technique has itsown limitations. (a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a major technical difficulty arises in drawing a sharp line of demarcation between fixed and variable costs. the distinction between them holds good only in the short run. In the long-run, however, all costs are variable. (b) In marginal costing, greater importance is attached to the sales function thereby relegating the production function largely to a secondary position. But, the real efficiency of a business is to be assessed only by considering the selling and production functions together.
    • (c) The elimination of fixed costs from the valuation of inventories is illogical since fixed costs are also incurred in the manufacture of goods. Further, it results in the understatement of the value of stock, which is neither the cost nor the market price. (d) Pricing decision cannot be based on contribution alone. Sometimes, the contribution will be unrealistic when increased production and sale are effected, either through extensive use of existing machinery or by replacing manuallabour by machines. Another possibility is that there is danger of too many sales being effected at marginal cost, resulting in denial to the business of inadequate profits. (e) Although the problem of over or under absorption of fixed overheads can by overcome to a certain extent, the same problem still persist with regard to variable overheads. (f) The application of this technique is limited in the case of industries in which according to the nature of business, large stocks have to be carried by way of work-in-progress (e.g. contracting firms)Practical Applications of Marginal Costing (a) Profit Planning: A business concern exists with the objective of making profits, and profits are the yardstick of its success profit planning is therefore a part of operations planning. It is the basis of planning cash, capital expenditure, and pricing. If growth and survival of a business are to be ensured, profit planning becomes an absolute necessary. Marginal costing assists profit planning through computation of contribution ratio. It enables planning of future operation in such a way as to either maximize profits pre maintain specified levels of profit. Normally, profits are affected by several factors, such as the volume of sales, marginal cost per unit, total fixed costs, selling price and sales mix etc., Hence management can achieve their profit goals by varying one or more of the above variables. Basic marginal costing equations which are useful in profit planning are as follows.Profit volume ratio (p/w ratio). This is the ratio of contribution to sales. Symbolically it isexpressed as: ContributionC/S ratio or P/V ratio = --------------------------------- x 100 (1)(as a percentage) Sales (S)Contribution = Sales x P/V ratio (2) Contribution
    • Sales = -------------------------- (3) P/V ratioBrake Even point (BEP). This may be defined as that point of sales volume at whichtotal revenue is equal to total costs. it is a no-profit no-less point. It may be derived fromthe equation (3). We may get Contribution at BEPBEP (in Rs.) ----------------------------- P/V ratioAt BEP, the contribution will be equal to fixed cost and therefore, the formula may berestructured as follow: Fixed CostBEP (in Rs.) = --------------------------- P/V ratio Fixed Cost (F)BEP (in units) = ----------------------------- Contribution per unitMargin of Safety (MS) : This represents the difference between salew or production atthe selected activity, and the break-even sales or production.MS = Sales at the selected activity --- BEP CSales at the selected activity = ---------------------- P-V ratio F BEP = ---------------------- P/V ratio C F profit (p)MS = ------------------------- ------------ ------------------- = --------------------------- P/V ratio P/V ratio P/V ratioWhere C-F = PMargin of safety is also presented in percentages as follows:
    • MS (Sales) x 100 ----------------------------------------- Sales at selected activityIllustration 2From the following information, calculate BEP and determine the net profit if sales are25% above BEPSelling price per unit Rs. 50Direct material cost per unit Rs. 20Direct wages per unit : Rs. 10Variable overheads per unit : Rs. 7.5Fixed overheads (total) Rs. 50,000SolutionMarginal Cost Statement Rs. Selling price per unit 50.00 Less: marginal cost per unit Rs. Materials 20.00 Wages: 10.00 Variable overheads: 7.50 37.50 Contribution: 12.50 C 12.50 P/V ratio = ------------- x 100 = ---------------- x 100 = 25% S 50
    • F Rs. 50,000 BEP = ---------------- = ----------------------- x 100 = 2,00,000 P/V ratio 25BEP = Rs. 2,00,00025% of BEP = Rs. 50,000 -----------------------Total sales Rs. 2,50,000Contribution = Sales x P/V ratioContribution at Rs. 2,50,000 sales = Rs. 2,50,000 x 25% Contribution = Rs. 62,500 Less: Fixed cost = Rs. 50,000 -------------------- Net profit = Rs. 12,500 -------------------- (b) Level of Activity PlanningBusiness concern may have plans either to expland or contract the level of activitiesdepending upon the conditions prevailing in the market. Such planning is to beconsidered before events overtake the business. Marginal costing is very useful fortaking such decisions by enabling management to compare the contribution at differentlevels of activities.
    • Illustration 5Following is the Cost Structure of JB limitedLevels of ActivityOutput (in puts) 60% 70% 80% 2,400 2,800 3,200Costs (Rs.)Materials 48,000 56,000 64,000Wages 14,400 16,800 19,200Factory overheads 25,600 27,200 28,800Factory cost 88,000 1,00,000 1,12,000The factory is considering an increase of production to 90% level of activity. No increasein fixed overheads is expected at this level. The management requires a statementshowing all details of factory costs at 90% level of activity.
    • Solution Marginal Cost Statement Level of activity = 90% Output = 3.600 units Total cost Per unit Rs. Rs.Material 72,000 20.00Wages 21,600 6.00Variable overheads 14,400 4.00 1,08,000 30.00Fixed overheads 16,000Total factory cost 1,24,000Note: Factory overheads increase by Rs. 1,600 at each level of activity. Therefore,variable overheads must be Rs. 1,600 ----------------- = Rs. 4 per unit. At 80% level of activity, Factory overheads 400 unitsare Rs. 28,800 of which variable cost are Rs. 12,800 (Rs. 4 x 3,200), resulting in fixedoverheads of Rs. 16,000 (Rs. 28,800 – Rs. 12,800). (D) Profitable Mix of SalesA company which has a variety of product lines can employ marginal costing in order todetermine the most profitable sales mix from a number of selected alternatives.Illustration 6
    • The directors of AB Ltd. are considering the sales budget for the next budget period.The following information has been made available form the cost records. Product Z Product Y (per unit) (per unit)Directed materials Rs. 40 Rs. 50Selling price Rs. 120 Rs. 200Direct wages (a)Rs. 2 per hour 10 hours 15 hoursVariable overheads : 100% of direct wagesFixed overheads : Rs. 20,000 p.a.You are required to present to the management a statement showing the marginal costof each product, and to recommend which of the following sales mix should be adopted. (a) 450 units of Z and 300 units of Y (b) 900 units of Z only (c) 600 units of Y only (d) 600 units of Z and 200 units of Y
    • Solution Marginal cost statement Per unit Product Z Product Y Rs. Rs. Rs. Rs.Selling price 120 200Less: MaterialscostDirect materials 40 50Direct wages 20 30Variable 20 80 30 110overheads 40 90 Selection of Alternatives Products Z Y Total Rs. Rs. Rs.450 – 300 – Y 18,000 27,000 45,000Contribution(450 x Rs. 40)+ (300 x Rs.90)Less: Fixed 20,000over-headsProfit 25,000900 – ZContribution 36,000 36,000(900 x Rs. 40)Less fixed cost 20,000Profit 16,000
    • (c) 600 – Y 54,000 54,000Contribution(600 x Rs. 90)Less: fixed cost 20,000 Profit 34,000600 – Z, 200 – 24,000 18,000 42,000Y Contribution(600 x Rs. 40) 20,000+ (200 x Rs.90) Less: FixedcostProfit 22,000Thus, alternative (c) is the one recommended.(d) Marginal Costing and PricingDetermining the price of products manufactured by a company is often considered to bea difficult problem. However, the basic problem involved in pricing is the matching ofdemand and supply. Marginal costing is something used to determine prices, a simpleand familiar example being the railway ticket. The normal fare will usually be more thanthe charge collected for excursion fare (concessional fare) for, the normal fare iscalculated to cover all the railway costs, including fixed overheads which are aconsiderable item, whereas the excursion fare will probably cover only the marginal cost(which is relatively small) and some contribution towards profit. The marginal costingtechnique can help management in fixing price in such special circumstances as: (a) A trade depression in the industry. (b) Spare capacity in the factory (c) A seasonal fluctuation in demand. (d) When it is desired to obtain a special contract.Cost – volume – profit AnalysisCost – volume – profit (CVP) analysis is an analytical tool for studying the relationship
    • between volume cost, price and profits. It is an integral part of the profit planningprocess of the firm. However, formal profit planning and control involves the use ofbudgets and other forecasts, and the CVP analysis provides only an overview of theprofit planning process. Besides, it helps to evaluate the purpose and reasonablenessof such budgets and forecasts. Generally, CVP analysis provides answers to questionssuch as: (a) What will be the effect of changes in prices / costs and volume on profit? (b) What minimum sales volume need be effected to avoid losses? (c) What should be the level of activity to earn a target profit? (d) Which product is the most profitable and which product or operation of a plant should be discontinued? EtcBreak – Even Analysis The break-even analysis is the most widely known from of the CVP analysis. Thestudy of CVP relationship is frequently referred to as break-even analysis. However,some state that up to the point of activity where total revenue equals total expenses, thestudy can be called as break-even analysis and beyond that point, it is the application ofCVP relationship.Thus, a narrow in depredation of break-even analysis refers to a system of determiningthat level of activity where total revenue equals total cost i.e. the point of zero loss. Thebroader interpretation denotes a system of analysis that can be used to determine theprobable profit at any level of activity.Practical Utility of Break-even AnalysisBreak-even Analysis can be used to show the effect of a change in any of the followingprofit factors: (1) Change in selling price (2) Change in volume of sales (3) Change in variable costs (4) Change in fixed costs
    • LESSON 20 MANAGEMENT REPORTINGInformation is the basis for decision making in an organisation. The efficiency ofmanagement depends, to a larger extent, upon the availability of regular and relevantinformation to those exercise the managerial functions. No planning and controlprocedure is complete without prompt and accurate feedback of operation results andavailability of other information. For example, management must know how the actualprofit performance collates with that of budgeted or standard or with past performancesand to what extant the variation have been caused by various influencing factors. Aregular system of reporting is considered as a better guarantee of efficiency andoperation than reliance on personal qualities. Hence, it is essential that an effective andefficient reporting system is developed as part of accounting methods.MeaningThe term ‘reporting’ connotes different meanings as under: (A) Narrating some facts (B) Reviewing certain matter with its merits and demerits and offering comments. (C) Furnishing data at regular intervals in standards form. (D) Submitting specific information for particular purpose upon specific request instruction.Management reporting refers to the formal system whereby relevant requiredinformation is furnished to management by means of reports constantly. Thus, ‘report’ isthe essence of any management reporting system.The term ‘Report’ normally refers to a formal communication which moves upward, i.e.,for factual communication by a lower to a higher level of authority in response to orderreceived from higher level. Reports provide means of checking the performance. Aperson, who is issued with orders or instructions to do certain things should report backwhat he has done in compliance thereof. Reports may be oral or written and alsoroutine or special.
    • Objects of ReportingThe primary object of management reporting is to obtain the required information aboutthe operating results of the organisation regularly in order to use them for futureplanning and control. Another object is to secure understanding and approval of thejudgment by the people engaged in various aspects of the work of enterprise. Thesecond object is closely related to the first one and is important in terms of efficiency,morale and motivation.Essentials of a Good Reporting SystemReporting system enables management at all levels to keep itself abreast of pastperformance as well as developments and it facilitates a check on individual operatinglevels. Based on reports, management takes crucial decisions. Hence, the essentials ofgood reporting system are as follows: 1. Proper form: In order to facilitate decision-making the information should be supplied in form. 2. Proper time: Promptness is very important because information delayed is information denied Reports are meant for action and when adversetendencise or events are noticed, action should follow forthwith. The sooner the report is made the quicker can be the corrective action taken. 3. Proper flow of information: The information should flow from the right level of authority to the level of authority where the decision are to be made. Further a complete and consistent information should flow in a systematic manner. 4. Flexibility: The system should be capable of being adjusted according to the requirement of the user. 5. Facilitation of evaluation: The system should distinctively report deviations from standards or estimates. Controllable factors should be distinguished from non- controllable factors and reported separately. 6. Economy: There is a cost for rendering information and such cost should be compared with benefits derived from the report or loss sustained by not having the report. Economy is an information aspect to be considered while developing reporting system.Models of ReportingReports may be presented in the form of written statements, graphs, abd or oral. 1. Written statements
    • a. Formal financial statements: These statements may deal with any one or more of the following: i. Actual against the budgeted figures. ii. Comparative statements over a period of time b. Tabulated statistics: This statement may deal with statistical analysis of a particular type of expenditure over a period of time or sales of a product over a period in different regions, etc. c. Accounting ratios: The ratios may either form part of the formal financial statement or be given in the form separate statement. 2. Graphic reports The information may be presented by means of graphic reports which give a better visual view of the data than the long array of figures given instatements. Charts, diagrams and pictures are the usual form of graphic reports. They have the advantage of facilitating quick grasp of significant trends by receivers of information. 3. Oral reports Oral reports are mostly presented at group meetings and conferences with individuals.Basic Requisites of a Good ReportA report is a vehicle carrying information to different levels of administration. Quality ofdecision-making depends to a large extent on the quality of information supplied and onthe promptness and consistency of reporting. Good reporting is necessary for effectivecommunication. hence a good report should possess the following basic requisites. 1. Promptness: It means that report must be prepared and presented on time. 2. From and content: A good report should have a suggestive title, headings, sub- headings, paragraph divisions, statistical figures, facts, dated etc. 3. Comparability: Reports are also meant for comparison. 4. Consistency: consistency envisages the presentation of the same type of information as between different reporting periods. Uniform procedure should be followed over period of time. 5. Simplicity: The report should be in a simple unambiguous and concise form 6. Controllability: It is necessary that every report should be addressed to a responsibility centre and present controllable and uncontrollable factors separately.
    • 7. Appropriateness: Reports are sent to different levels of management and the form should be designed to suit the respective levels. 8. Cost considerations: The cost of maintaining the reporting system should commensurate with the benefits derived there form. 9. Accuracy: The report should be reasonably accurate.Types of reportsRoutine ReportsReports which are submitted at periodical intervals on a regular basis covering routinematters e.g., variance analysis, financial statements, budgetary control statements areroutine reports.Special ReportsReports which are submitted on particular occasions on specific request or instructionare special reports.Operating ReportsThese reports may be classified into control report information – cum-venturemeasurement report.Control ReportIt is an important ingredient of control process and helps in controlling different activitiesof an enterprise. It provides information properly collected and analyzed to differentlevels of management.Information ReportThese reports provide information which are very much useful for future planning andpolicy formulation.Financial ReportsThese report contain information about the financial position of the business. They maybe classified into Static Reports and Dynamic Reports. Static reports reveals the
    • financial position on a particular data e.g., balance sheet of a company. On the otherhand, the dynamic report reveals the movement of funds during a specified period e.g.Fund flow statement, Cash flow statement.
    • MANAGEMENT ACCOUNTING MODEL QUESTION PAPERTime: 3 Hours Max. marks: 100 PART – A (6 x 5 = 30) Answer any SIX questions All questions carry Equal marks Each answer to a theory question need not exceed One page 1. State the significance of management accounting. 2. What are the limitations of financial statements? 3. What is debt service coverage ratio? 4. State the significance of capital budgeting? 5. What is common size financial statements? 6. Determine which company is more profitable. A Ltd. B Ltd Net profit ratio 5% 8% Turnover ratio 6 times 3 times 7. Calculate the funds from operations from the following profit and loss account: P & L A/c To Salaries 5,000 By Gross profit 50,000 To Rent 3,000 By Profit on sale of 5,000 buildings To depreciation on plant 5,000 To Printing & Stationary 3,000 To Goodwill written off 3,000 To Preliminary expenses 2,000 written off To Provision for tax 10,000 To Net Profit 24,000 55,000 55,000
    • 8. Calculate from the following information the break-even point and the net profit if the sales volume is Rs. 8,00,000, P/V ratio is 40% and margin of safety is 25%.9. Prepare a production budget for three months ending March-31, 1999 for a factory producing four products, on the basis of the following information: Types of product Estimated stock Estimated sales Desired closing on 1 – 1 – 1999 during Jan – Stock on 31-3-99 (units) March 1999 (units) (units) A 2000 10000 3000 B 3000 15000 5000 C 4000 13000 3000 D 3000 12000 2000 PART – B (5 x 14 = 70) Answer any FIVE questions All questions carry EQUAL marks Each answer to a theory need not exceed Three pages.10. What is budgetary control? What are the objectives and advantages of budgetary control?11. Discuss the different methods of ranking investment proposals.12. What are the functions of management accounting?13. X Ltd., furnishes you the following information: Year 1998 I Half II Half Sales Rs. 8,10,000 10,26,000 Profit 21,600 64,800From the above you are required to compute the following assuming that the fixed cost remains the same in both the periods:i) P/V ratioii) Fixed cost
    • iii) The amount of profit or loss where sales are Rs. 6,48,000iv) The amount of sales required to earn a profit of Rs. 1,08,000v) From the balance sheets of A Ltd.; make out i) a statement of changes in the working capital and ii) Fund Flow statement. 1995 1996 1995 1996Share Capital 4,50,000 5,00,000 Goodwill 1,15,000 90,000General reserve 40,000 70,000 Plant 80,000 2,00,000Profit & Loss A/c 30,000 48,000 Buildings 2,00,000 1,70,000Creditors 97,000 1,33,000 Debtors 1,60,000 2,00,000Bills payable 20,000 16,000 Stock 97,000 1,39,000Provision for Tax 40,000 50,000 Bank 25,000 18,000 6,77,000 8,17,000 6,77,000 8,17,000 ***************