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• 1. NOTES FOR MBA – 1ST SEMESTER M. D UNIVERSITY, ROHTAK SUBJECT: - ACCOUNTING FOR MANAGERS Ratio AnalysisRatio Analysis is a technique of analyzing financial statements. It helps in estimatingfinancial sounders or weakness. Ratio is quantitative relationship between two items for thepurpose of comparison. The items presented in profit and loss account and balance sheetare related to each other. This relationship can be calculated with the help of ratios. Forexample, profit is related to capital invested in business and debtors are related to creditsales. Thus ratio helps in drawing meaningful conclusions by establishing relationshipbetween various facts. On the basis of their inter-pretation, unfavorable situations in thefuture can be avoided. Hence, comparative and significant conclusions cannot be drawnfrom financial data of different years of a business or of different businesses unlessarithmetic relationship is established among such data.Definition:-According to J.Batty-“ The term accounting ratios’ is used to describe significantrelationship between figures shown on a balance-sheet, in a profit and loss account, in abudgetary control system or in any their part of the accounting organization.”Thus ratio analysis is a process where by the financial statement is analysis and interpretedthrough ratios.Forms of Expressing Ratio:- 1) Proportion:- If the current assets of a business are Rs. 5,00,000 and current liabilities Rs. 2,50,000 the proportion of current assets and current liabilities will be 5,00,000:2,50,000 or 2! 2) Percentage: - In it the relationship between 2 numbers is expressed in percentage form. If the gross profit of business is Rs. 50,000 and sales are Rs. 2, 00,000 the gross profit is 25% of sales i.e. 50,000*100=25% 2, 00,000Classification of ratio:-According to purpose:- a) Liquidity Ratios b) Profitability Ratios c) Turnover or performance or Activity Ratios d) Leverage or Capital structure ratios a) Liquidity Ratios: - It is also called as working capital or short terms solvency ratio. For the insistence of firm adequate liquidity is essential. Liquidity means ability of the firm to pay its short terms debts in time, liquidity ratios are calculated to measure
• 2. short terms financial position or short terms solvency of the firm. Commercial banksand short terms creditors are interested in such type of analysis. Management can alsomake use of these ratios to find out how efficiently working capital is being used.The important Liquidity ratios are as follows:-i) Current Ratio:-This ratio establishes the relationship between current assets and current Liabilities. It iscalculated by dividing current assets by current liabilities. Ideal current ratio is 2% i.e.current assets should be twice the current liabilities. Current Ratio= Current Assets Current LiabilitiesCurrent assts are those assets which are converted into cash within one year or anoperation cycle. They include cash in hand, bank balance, stock, debtors, prepaidexpenses, bills receivable, marketable securities etc.Current liabilities are those liabilities which have to be paid during one year. Theseinclude creditors, bill payable, outstanding expenses, bank overdrafts etc. With its help, ability of the business to pay off its short term liabilities isdetermined. It helps to find out how many times current assets are there in business ascompared to current liabilities. Current assets should be more then current liabilities sothat despite fall in their prices, current liabilities could be paid easily. If current ratio is2:1, it means that current liabilities would be paid even if there is 50% fall in the pricesof current assets.Significance: - The greater this ratio better will be the short term slovely of firm andsafer will be the interest of short term creditors. This ratio should neither be too highnot too low... High ratio is an indicator of weak investment policy of the firm and lowratio increase the risk in payment of short term debts. High ratio also means that fundsof firm are lying surplus and unutilized. Current Ratios main limitation is that it is a quantitative measuring, not aqualitative one. To ascertain this ratio, all current assets are given equal importance andignore individual attention to assets. There is different in liquidity of various currentassets. Cash is most liquid assts. On the other-hand, stock is least liquid of all currentassets. Debtors, bill recoverable etc. are more liquid as compared to stock but lessliquid then cash.ii) Liquid Ratio/Acid test Ratio/Quick Ratio:-This ratio establishes the relationship between liquid assets and current liabilities.Liquid Ratio = Liquid Assets Liquid liabilities
• 3. Liquid Assets are those assets which can immediately or in a short period be Converted into cash without much loss. Liquid assets do not include stock and prepaid expenses because stock is less liquid and its prices fluctuate. Prepaid expenses cannot be realized. ⇒Liquid Assets=Current Assets-stock-Prepaid Expenses an ideal liquid ratio is 1:1 With the help of this ratio, capacity of firm to pay off its current liabilities immediately is measured. iii) Absolute liquidity Ratio or Super Quick Ratio or Super acid test Ratio:- This ratio is calculated by dividing absolute liquid assets by current liabilities. Super liquid assets = cash+ Bank + Marketable securities Ideal absolute liquidity ratio is 0.5:1. It means that for every Rs. 2 liability there should be super acid assets of 50 paisa. This ratio is not used much practically. Absolute liquidity Ratio= Cash + Bank + Marketable security Current liabilities ii) Turn Over/Activity/Efficiency Ratio:- The efficiency of a firm depends on the fact how efficiently its assets are being used in business. The effective utilization of these assets depends on the speed at which these assets are converted in sales. Higher velocity of their conversion in sales indicates that assts are being efficiently managed. Various type of turnover ratios are:-1) Inventory turnover ratio: - This ratio establishes relationship between costs of goodssold and average inventory. It indicates the fact whether the investment in inventory iswithin a proper. Limit or not. With the help of this ratio, it can be ascertained how manytimes the stock has been converted in to sales during the year. It helps evaluate inventorypolicy of management. Inventory turnover Ratio = Cost of goods sold Average Inventory Average Inventory = Opening + closing stock 2 Cost of goods sold = opening stock + Purchases + Direct Expenses Including manufacturing expenses-Closing stock OR = Sales-Gross Profit
• 4. Sometimes, it is difficult to calculate cost of goods sold on basis of available information. In such case net sales are used in place of cost of goods sold. Inventory turnover ratio = Net sales Average Inventory Similarly, if the amount of opening stock is not given in question, closing stock is taken in place of average stock. When more then one type of stock is used, for example, stock of raw material stock of working progress and stock of finished goods, then for calculating turnover ratio for each component, the fall ratio should be used:- Raw Material Turnover Ratio= Cost of R.M concerned Average stock of R.M. W.I.P Turnover Ratio = Cost of goods Manufactured Average W.I.P Inventory Significance:- It measured rate of sale of stock. It acts as a yardstick of efficient inventory management. The higher this ratio, the better will be, because it is an indicator of efficient inventory management. It means that stock is being sold fast after its purchase and it has not to be kept in go down for a long time. But a high turnover ratio should be analyzed carefully as it may result in lower investment in inventory. Lower investment in inventory may result in serious consequences in future. Firm may not be able to fulfill demand of its customers. Due to lessees availability of raw material production process may stop. Lower inventory turnover ratio is an indicator of in efficient management. It expresses fact that greater investment has been made in inventories. And may result low quality of production, valuation of closing stock at high price, including of worthless and old product in stock etc. To draw meaningful conclusions from this ratio it should be compared with ratio of previous years and with That of other firms. This ratio is not standardized because it depends on ratio of nature of industry.Precautions: - While using this ratio care must be taken regarding following factors:- 1) Seasonal Conditions: - If the balance sheet is prepared at the time of stock season, average inventory will be much less which may give a very high turnover ratio. 2) Supply Conditions: - In case of conditions of scarcity, inventory may have to be kept in high quality for meeting future requirements. 3) Price Trends:-In case of possibility of a rise in prices. Larger inventory may be kept by business. Reveres will be the case if there is possibility of a fall in prices. 4) Trend of volume of business: - In case there is trend of sales being sufficiently higher then sales in past, a higher amount of inventory may be kept in past, a higher amount of inventory may be kept.
• 5. Debtors Turnover ratio:- Debtors or receivable are current assets of business. It measures how quickly debtors of business are realized and indicates liquidity of debtors. This ratio established relationship between credit sales and average debtors. Account receivable include debtors and bill receivable average receivables are calculated by dividing sum of opening and closing balance of receivable by two Debtors turnover ratio= Credit sales Average Account Receivable Average Account Receivables= Opening (Debtors &B/RS) + Closing (Debtors & B/Rs) 2 In case information about credit sales and average debtors is missing this ratio is calculated on the basis of total sales and closing date balances of receivables. Debtors turnover ratio= total Sales Accounts receivable (closing)The second ratio related to debtor’s turnover is average collection period. This ratio iscalculated by dividing days in a year by debtor’s turnover ratio. And indicates to whatintent debts have been collected in time.Debt collectors period= Months or days in a year Debtor’s turnoverAverage collection Period ORAverage A/cs Receivable Credit sales Per DayCredit sales per day= Total credit sales Days in a year
• 6. Significance:- High debtor turnover ratio and low collection period is an indicator of efficientmanagement of debtors. Higher the debtors turnover ratio better it will be for the business.Similarly, low collection period indicates that debts are being realized quickly and nounnecessary funds are blocked in them. On the other hand, high average collection periodmeans that firm has used liberal credit policy and debts are realized at a slow rate or lesserefforts to realize debts have been made.Very small too. Although it indicates lower risk of bed debts but it can affect salesadversely. Thus debtor’s turnover ratio should not be very high or very low. Whether average collection period of a business is proper or not it can beexamined by comparing this ratio with ratio of other firms in industry. As comparedto average of industry, a firm should neither use a liberal credit policy not creditpolicy should be restrictive. Actual collection period of firm should be compared withstandard and on this basis credit policy can be evaluated. For example, it pre-determined collection period is 30 days and actual collection period is 45 days, itmeans firm is following liberate credit policy and debtors are not being realized intime.3) Creditors turnover ratio:-n This ratio establishes relationship between creditpurchases and creditors high creditors turnover is an indicator of fact that firm payits creditors quickly which increase its credit worthiness. Creditors turnover ratio= Credit purchases Average accounts payableTotal purchase-cash purchase= credit purchase.Account payable includes both creditors and bill payable.Average payment period= months or days in a year Creditors turnover ratioOr Average accounts payable Credit purchase per day4) Working capital turnover ratio: - This ratio indicates whether working capital hasbeen efficiently used to increase sales.Working capital= current Assets-Current liabilities
• 8. Debt Equity Ratio= External Equities Internal EquitiesExternal Equities= Debatesnres + Long term loans + short term creditors OR Long-term debt + c. l.Internal EquitiesOrShareholders funds= Equity share capital + preference share capital + Capital reserve + revenue reservesInternal equities are also called net worth. Thus, the ratio establishes relationship between internal funds and externalfunds of business.Generally this ratio of 1:1 is considered satisfactory. This ratio can also be expressedin various other ways. a) Debt-equity ratio= total long-term debt Total long-term fundsb) Debt-equity ratio = Shareholder’s funds Total long-term funds b) Debt-equity ratio= Total long-term debt Total long-term funds c) Debt-equity ratio= Total long-term debt Shareholders fundsFirst (a) ratio expresses the relationship between long term debts)Second (b) ratio explains the relationship between share holds funds and total longterm funds.Third (c) ratio establishes relationship between long terms debts and share holdsfunds.
• 9. In case of (a) and (b) a ratio of 0.5:1 and in case of (c) a ratio of 1:1 is considered idealand satisfactory. Significance:-This ratio is very significant for the evaluation of capital structure of a firm. Thisratio explains the fact in what proportion the owners and credit ions of the businesshave provided funds. Creditors can know whether their interest is safe or not. If theshareholders funds are increasing, their interest will continue to be safe. On the otherhand, if the funds provided by creditors are increasing, their interests can beendangered. If the debt equity ratio is 1:23, it means that fir every one rupee ofexternal liability, there are 2 Rs. Of shareholders funds, ∴ coeditors have a safetymargin of 50%... If the debt-equity ratio is quite high, creditors of the firm will try tointerface in the affairs of the firm. The firm may have to bear a burden of fixedinterest changes in the years of low profit. It will also have to accept restrictiveconditions for raising further funds in future. But the owners of business will controlthe affairs with their limited funds. If the firm can earn high rate of profit ascompared to the rate of interest payable, it can maximize the return for shareholdersby using high debt equity ratio.ii) Proprietary Ratio: - It is another form of debt equity ratio and also known as networth to total assets ratio. It established the relationship between shareholders fundsand total assets of business. Its main objective is to find out how much funds havebeen provided by shareholders for investment in assets of business.Proprietary ratio= Shareholders funds Total AssetsShareholders funds= ordinary share capital+ Preference share capital + Capital and revenue reservesSpecial reserves for specific objective should be included.Total assets= Fixed assets + current assetsThe intangible assets like goodwill, potent, etc. should be included to the extent oftheir market value. Significance:-This ratio is quite significant for the creditors of business. With the help of this ratio,it can be ascertained in what proportion owners have provided funds for investmentin assets of business. The higher the ratio, the more profitable it is for the creditorsand the less management will have to depend external funds. If the ratio is low thecreditors can be suspicions about the repayment of their debt on liquidation ofcompany∴, external funds should be utilized to a limited extent...
• 10. Fixed Assets Fixed Assets are included after changing depreciation. Owner’s funds are the same as internal equities in the debt equity ratio. The higher value of proprieties funds over fixed assets in a measured of long term financial soundness of long term financial soundness of business. The lower the berrer will be for the long term solvency of business because proprietor’s funds will be available for working capital capital also. For example, if the fixed assets are Rs. 18000 and proprietary funds are rs. 24,000 this ratio will be 0.75 ( Rs. 18,000 ). It means that 75% of proprietary Rs. 24,000Funds are invested in fixed assets and balance 25% are used as working capital. Forindustrial units the standard is usually 5% if the ratio is more than one, it means that a partof fixed assets has been debt capital? iii) Current assets to proprietary funds ratio: - This ratio establishes relationship between current assets and proprietary funds. The main objectives of proprietary fund have been invested in current assets. Formula, Current Assets Proprietary fund iv) Capital gearing ratio: - Establishes relationship between ordinary share capital and fixed cost bearing securities. In fixed cost bearing capital we include performance share capital and debt funds. Fixed cost bearing capital= debentures + performance share capital+ Mortgage loan Equity shares capital Capital gearing ratio= Fixed cost bearing capitalIf in capital structure of firm, fixed cost sear ties are more than equity share capital it willbe called high capital gearing. On the other hand, of amount of fixed cost bearing securitiesis less than amount of equity share capital, it will be low capital gearing. The mainobjective of searing fixed cost bearing capital in capital structure is to maximize return forequity shareholders. Shareholders get residual profit after paying fixed interest on loans andfixed rate of dividend to performance shareholders. Profitability Ratio: - Profitability strengthens the long-term solvency of the business. Low profitability isthe result of higher expenses or lower sales. Therefore, profitability ratios arecalculated to know answers of the following questions:-
• 11. i) Are the profit earned by the firm adequate? ii) What is the rate of return on capital employed? iii) What is the rate of net profit and gross profit on sales? iv) What is the earning per share? v) How much divided was distributed? vi) What is the rate of return on shareholder’s funds?Profitability ratios can be calculated on the basis of sales or capital employed. Profitability Ratio Related to Sales:-These ratios are calculated on the basis of sales. If a firm does not earn adequate profit onsales, it will be difficult for it to pay operating expenses and the owners will not get anyreturn. These ratios are as under. 1. Gross profit ratio: - This ratio establishes relationship between gross profit and sales. It can be calculated as under:-Gross profit ratio= gross profit Net Sales *100Net sales= gross sales-sales returnGross profit= Net sales-Cost of goods soldCost of goods sold in a trading concern is calculated by adding stock, purchases anddirect expenses and sub trading the closing stock... In case of firms engaged inmanufacturing of goods, cost of goods sold is equal to the cost of raw material, directlabor, direct expenses and manufacturing expenses. Gross profit is the result of ratio on slip among sales and costs and price. It canbe sed or reduced by changing any of these variables. High gross profit is the signof efficient management. Increase in price or reduction in costs can also result in highgross profit ratio. Sometimes, lowerValuation of opening stock or higher valuation of closing stock, can also increasegross profit ratio∴, the reason for high or low gross profit ratio should be properlyanalyzed. These can be several reasons for low gross profit ratio, such as high cost ofproduction over valuation of opening stock and under valuation of closing stockreduction in selling price of goods, low demand etc. The rate of gross profit in abusiness should be such that divided at the proper rate could be given to the ownersafter meeting firms all operations expenses and fixed costs.Example:-Q. Compute the gross profit ratio from the following particulars:- Rs. Rs.
• 12. Opening stock 50,000 Purchase returns 4,000Purchase 1, 60,000 Sales 2, 10,000Closing Stock 70,000 Sales Returns 10,000Solutions:-Cost of goods sold= Opening stock + Net purchases-closing stock =Rs. 50,000 + (Rs. 1, 60,000-Rs. 4,000) –Rs. 70,000 = Rs. 1, 36,000Gross Profit= Net Sales-Cost of goods sold = (Rs. 2, 10,000-Rs. 10,000) - Rs. 1, 36,000 =Rs. 64,000Gross Profit Ratio = Gross Profit *100 Net Sales Rs. 64,000 *100= (Rs. 2, 10,000-Rs. 10,000)=32% 5) Return on shareholders fund:- Return on capital employed highlights overall profitability on funds invested by creditorsand shareholders. Return on shareholders fund evaluates prop ability of funds invested byowners. Dividend to preference shareholders is paid out of earning after tax and balance ofprofits is available out of equity shareholders. These are various measures for return onshareholders fund- a) Return on total shareholder fund. b) Return on equity shareholders fund. c) Earning per share.Price evening ratio= It is calculated by dividing market price of a share by earning pershare. P/E ratio= Market price of share EpsThis ratio indicates what value of shares fetches from market for each rupee of Eps. It alsotells us whether share of a company are valued high or low. d) Dividend per share e) Dividend payout ratio f) Dividend and Earning yield g) Price earning ratio.
• 13. a) Return on total shareholders funds: - To calculated this ratio net profit taxes are divided by total shareholders funds. With the help of this ratio, it can be ascertained how effectively the funds of the shareholders are being utilized. Relative profitability and soundness can be evaluated by comparing this ratio with that of other firms. Shareholders’ Funds are also known as Net Worth. b)Return on total shareholder’s equity or funds = Net profit after tax Total shareholders equity *100 c) Return on equity shareholders’ funds: - Equity shareholders are the actual owners of business because they bear all risk. They participate in management. They are the owners of all their profits lefts paying the dividend to performance shareholders. Therefore, it is essential to evaluate the profitability of the business from viewpoint of ordinary shareholders. This ratio is calculated by dividing the net profit after taxes and preference dividend by equity shareholders’ funds.Return on Equity shareholders’ funds= net profit after tax and preference dividend Equity shareholder’ funds *100 d) Earning per share or EPS: - This ratio measures the earning per share available to ordinary shareholders. Equity shareholders have the right to all profits left after payment of taxes and preference dividend. This ratio is calculated by dividing the profit available for equity shareholders by the number of equity shares issued. Net profit after Tax and Preference Dividend EPS= Number of Equity SharesThis ratio is quite significant. EPS affects the market value of share. It is an indicator of thedividend paying capacity of the firm. By comparing the EPS with firm management canknow whether ordinary share capital is being utilized effectively or not. e) Dividend per share or DPS: - All the profit after tax and preference dividend available for equity shareholders is not distributed among them as dividend. Rather apart of it is retained in business. The balance of profits is distributed among equity shareholders. To calculate dividend per share, we divide the profits distributed as dividend among shareholders by number of equity shares. Profit distributed to Equity Shareholders DPS= Number of Equity Shares f) Dividend-Payout ratio or D/P ratio: - The ratio is also called pay out ratio. This ratio establishes relationship between the earning available for ordinary shareholders and the dividend paid to them. Total Dividend paid to Equity ShareholdersD/P=
• 14. Total net profit belonging to equity shareholders OR DPS D/p= EPS *100 g) Dividend and earning yield: - One more ratio can be used to evaluate the profitability from the stand point of ordinary shareholders. It is known as dividend and earning yield. Earning per share (EPS) and dividend per share (DPS) are calculated on the basis of book value of share but yield is always calculated on the basis of market value of sharers. This ratio is also called earning price ratio. DPS Dividend yield= Market value per share EPS Earning yield= Market value per shareSignificance of Ratio-AnalysisRatio analysis is an important technique of analysis of financial statement. It helps todetermine efficiency of business as well as short term and long-term financial soundness ofbusiness on the basis of which management can take various important decisions. It is notonly significant for management but also for all parties including creditors, investors andfinancial institutions. Following are the main uses of ratio analysis.- 1) Useful in analysis of financial statements:-According ratios are useful for understanding financial position of concern. One mayquickly perceive the relationships without working out the ratio, but that merely givesroughly idea. According ratios are an extremely useful device for analyzing the financialstatements- the B/s and profit and lossFigures alone convey no meaning. A ratio becomes significant only when considered alongwith other figures. Thus, “Financial ratio are useful because they summaries briefly the results ofdetailed and complicated computations.” 3) Useful in Judging the operating efficiency of Business:-Ratio analysis is also helpful it assess the managerial efficiency. It helps to determinewhether the assets are being used optimally or not. They are also useful for diagnosis offinancial health of business concern, which is done by evaluating liquidity, solvency,
• 16. Except in few cases, a/citing ratios by themselves are not significant- they assumesignificance only when compared with the relevant rations of other firms (or of theindustry in general) or of the previous periods. The profit of a firm to sales is 5%:whether this is satisfactory or not will depend upon the figures for the previous years orfigures for the other firm. Thus to get the true message from the ratio’s relating to a firm, they must be setagainst ratios of previous period or of other firms. The following are the mainlimitations of accounting ratios.Give false results if the ratios are based on incorrect accounting dataAccounting ratios are based on accounting dates. If accounting data is not correct ratioalso suffer from all weaknesses of the accounting system itself. For example, ifinventory values are inflated, not only will one have an encaggerated view ofprofitability of the concern, but also of its financial position. Therefore, unless thebalance sheet and the profit and loss account are reliable, the ratios based on therewould not be reliable. Thus, the basis data must be absolutely reliable, if the ratioworked out on its basis is to be relied upon.2) Different meaning are put on different terms:-Elements and sub elements of financial statements are not uniquely defined. A firmmay work out ratio on the basis of profit after interest and income tax; another firmmay consider profits before interest but after tax; a third firm may take profits beforeinterest and tax. Obviously, the ratios that will be worked out will be different and willnot be compatible. Before comparison is made, one must see the ratio have beenworked out on the same basis.3) Not comparable if different firm follow different accounting policiesWhen two firms result are being compared, it should be kept in mind that the firm mayfollow different accounting polices, For example, one firm may change depreciation onthe straight-line basis and the other on diminishing value. Such differences will notmake some of the accounting ratios strictly incomparable unless adjustment fordifferent accounting policies followed is made.3) Price level changes affect ratio analysis:-Changes in price level often make comparison of figures for the various years difficult.For example, the ratio of sales to fixed assets in 1944 would be much higher then 1990due to rising prices. This is because although sales are recorded in the price level of1994, fixed assets do not reflect their current value. It should, however, be noted in this;connection that the sales will be expressed in terms of current prices whereas the fixedassets would be expressed still on the basis of cost which is incurred in past. Hence,figures of the past years must be adjusted in the light of price level changes beforecomparing the ratios of these years.5) Result may be misleading in the absence of absolute data:- Ratios, sometimes give a misleading picture in the absence of absolute data fromwhich such ratios are derived. For ex. One firm produces 1000 units in one year and
• 17. 2,000 units next year; the progress is 100%. Another firm raises production from 6,000 units to 2,000 units the progress in only 33 1 %. The second firm will appear less active if 3 Than first firm if only the rate of increase is compared. It is therefore useful if, along with ratios, absolutes figures are also studied- unless the firm being studied is equal in all respects. In fact one should be extremely careful which compares the results of one firm with those of another, if two firms offer in any significant manner, say in size location etc. 6) Ignore qualitative factors:-Accounting ratios considers quantitative factors and ignore qualitative factors whichdistorted conclusions. For ex. - credit is granted to customer on basis of financial positionbut ultimately it also depends on managerial ability of customers. Under such circumstanceconclusion derived from ratio analysis would be misleading. 7) Limited use of single ratio:-Whatever the conclusions are drawn from anal sing the financial statement, they should notbe based on single ratios; rather all the related ratios should be considered for this purpose.Single ratio cannot provide all information’s on a particular aspects. For ex. On the basis ofall the current assets liquidity position of business can be considered sound but in case theproportion of stock in current assets is excessive the liquidity position cannot be consideredsound. Therefore all the ratios relating to liquidity should be calculated. 8) Difficulty in forecasting: - Ratio is calculated on the basis of previous year’s performance. To forecasting the future on their basis is difficult because it is not necessary that the part events like managerial policies, economic circumstances will continue in future also. Meaning of financial statementA financial statement is an organized collection of data. Its purpose is to convey financialaspect of business. It shows financial position through balance sheet and series of activitiesover a given period of time by income statement. Thus, the term financial statement refersto two basic statements –1. Income statement2. Balance sheetOf course business may also prepare3. Statement of Retained Earnings.4. Statement of changes in financial position. Financial Statements Income Balance Statement of Statement of Retained Earnings changes in Statement Sheet financial position
• 18. 1. Income statement/Profit & Loss Account – It explains what has happened to a business as a Result of operations between two balance sheet dates. For this purpose it matches revenues & costs incurred in process of earning revenue & shows net profit earned or loss suffered during a particular period.2. Balance sheet – It is a statement of financial position of a business at a specified moment of time. It represents all assets owned by business & equities of owner and outsides against those assets at that time. The difference between income statement and balance sheet is that income statement for a period & balance sheet on a particular date.3. Statement of Retained Earnings – Retained Earnings means accumulated excess of earnings over losses & dividends. The balance shown by Income Statement is transferred to balance sheet through this statement after making necessary appropriations. This statement is also transferred as Profit & Loss Appropriation A/C.4. Statement of changes in financial position –For better understanding of affairs of business, it is essential to identify movement of working capital or cash in or out of business, which is available in statement of changes in financial position.IMPORTANCE OF COST ACCOUNTINGThe limitations of financial accounting have made the management to realize theimportance of cost accounting. Whatever may be type of business, it involves expenditureon labour, material and other items required for the manufacturing of product. Asmanagement has to see that no machine remains idle, efficient & proper utilization ofproducts is made and costs are properly ascertained. Besides, management, creditors andemployees are benefited in many ways by installation of good costing system. Costaccounting serves as an important tool in bringing prosperity to nations. Thus, importancesof Cost Accounting are as under –a) Costing as an aid to management – It provides invaluable help to management. It provides detailed costing information to management to enable them to maintain effective control over stores and inventory to increase efficiency of organization and to check wastage and losses. It facilitates delegation of responsibility for important task. For all these, management should be capable of using information provided by cost accounts in proper way. The various advantages divided by management from good costing system are as follows –
• 19. 1) Cost accounting helps in period of trade depression and trade competition In period of trade depression, organization cannot afford to have losses, which pass unchecked. Management must know areas where economics may be sought, waste eliminated & efficiency increased. Organization should also create environment for its growth and should know actual cost of their product before starting any scheme of price reduction. Adequate costing facilitates this.2) Aids in price fixation Costing records help the producer to fix or change the prices of product though Law of Demand & Supply determines the price of articles to great extent.3) Helps in Estimates – The chances of losing a contract due to over-rating or under-rating can be minimized through adequate cost records because costing provides reliable basis upon which tenders and estimates may be prepared.4) Helps in canalizing production on right lines by making difference b/w profitable and non-profitable activities. Concentrating on profitable operation & eliminating non-profitable ones can maximize profit.5) Wastages are eliminated – As it is possible to know the cost of articles at each stage, it become possible to check various forms of waste such as time, expense etc. in use of machinery & tools etc.6) Makes comparison possible – Proper maintenance of costing records provides various costing data for comparison, which in turn helps management in formulation of future lines of action.7) Provides data for periodical Profit & Loss Account – Adequate costing records provide management with such data that are necessary for preparation of Profit & Loss A/C and balance sheet at regular intervals.8) Helps in determining & enhancing efficiency – Losses due to wastage of materials, idle time of workers, poor supervision etc. will be disclosed by cost accountant. Thus the efficiency can be measured, cost can be controlled and various steps can be taken to measure efficiency.9) Helps in inventory control – Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods.10) Helps in cost reduction – in long run when alternatives are tried. This is particularly important in present day content of global competition.
• 20. 11) Assists in increasing productivity – Productivity of material & labour is required to be increased to have growth and more profitability in the organization.b) Costing as an aid to Creditors – As investors, bankers and other moneylenders are interested in knowing success of business, so proper costing records help them in knowing profitability and future prospects of enterprise by studying reports submitted by cost accountants.c) Costing as an aid to Employees – Workers have vital interest in industry in which they work. If efficient costing system is installed they are benefited in number of ways because they get incentives, bonus as increase in consumer goods directly increases their remuneration.d) Costing as an aid to National Economy – An efficient costing system brings prosperity to business thereby resulting increased government revenue. The economic development of country takes place due to control of cost, elimination of wastages and thus nation as a whole is benefited.Rectification of ErrorsSometimes businessmen commit errors while posting Ledger. But it is not necessary sucherrors may be located at same time. Errors are generally located after accounts have beenclosed. Before knowing rectification of error, it is necessary to know kinds of errors. Errorscan be classified as follows –A. Errors of Omission – These are of 2 types – 1) Partial Omission: - When the transaction is partially not recorded in books of Accounts i.e. when transaction is entered in subsidiary book but is not posted to Ledger. Examples: a. Cash paid to supplier entered on payment side of cash book but not posted to debit of supplier’s account. b. A credit purchase entered in purchase book but not posted in to credit of supplier’s book. 2) Complete Omission: - Here the transaction is completely omitted from books. Examples: goods purchased from ‘A’ was not recorded anywhere in books.B. Error of Commission – Such error take place when some transactions is incorrectly recorded in books of Accounts. These mistakes arise often due to ignorance of bookkeeper. Examples: -
• 21. 1) Entering wrong amount in subsidiary book. A sale of Rs.350 may be entered in sales book as Rs.530 due to wrong transposition of figure.2) A sale transaction may be entered in Purchase book & Purchase transaction may be entered in Sales book.3) Wrong casting in subsidiary book. The daybooks are totaled periodically & amounts are posted to relevant accounts in Ledger. The process of totaling is referred to as casting. This has been explained as follows: - Purchase book Jan 1 X Rs.250 Jan 20 Y Rs.310 Jan 31 Z Rs.151 Rs.711 Getting this total is called Casting. Dr. X A/C Cr. By Purchase Rs.250 Dr. Y A/C Cr. By Purchase Rs.310 Dr. Z A/C Cr. By Purchase Rs.151 Dr. Purchase A/C Cr. To X 250 To Y 310 To Z 151 Or To sundries 211 Over or under casting4) Posting wrong amount to wrong side of proper account etc.
• 22. C. Error of Principle – Such error takes place when a transaction is recorded without having regard to fundamental principles of book-keeping and accountancy. Examples: - (1) Capital Expenditure may be treated as revenue expenditure or vice versa such as expenses incurred in constructing a go down are treated as repairs.D. Compensating Error – Sometimes deficiency of one error is compensated by another error. These are called compensating errors. Example: - A’s A/C was to be debited with Rs.10 but it was debited with Rs.100Cash BudgetCash budget is an important financial budget. Cash is center of all business decisions. Cashis invested in business to generate cash.According to Guttman & Dougal “Cash Budget is an estimate of cash receipts &disbursement for future period of time”.Objectives: -(1). To integrate cash inflows & outflows arising out of various functional budgets atdifferent time intervals, say monthly, quarterly or yearly.(2). To assess projected cash deficits, at different time intervals so that finance can beraised at required time to keep other activities of organization continue as per plan.(3). to assess projected cash surplus at different time intervals and draw investment plans sothat no cash remain idle.(4). to set limit of cash holding by organization at different point of time for smoothfunctioning. Utility/Importance:-(1). It ensures that sufficient cash is available when required.(2). It reveals surplus of cash so that suitable short-term or long-term investment plan maybe worked out.(3). It reveals whether cash expenditure projects can be financed internally.(4). It exercise control over cash & liquidity of firm.(5). It shows any expected shortage of cash so that action may be taken e.g. bank overdraftmay be arranged. Preparation:-Format of Cash Budget Budget period: Jan ______ to March ______
• 23. Particulars Jan (Rs.) Feb (Rs.) March (Rs.) Opening Balance (A)Cash ReceiptsCash SalesCollection fromDebtorsIssue of SharesRaising of loanIssue of debenturesSale of InvestmentsSale of Fixed AssetsTotal(B)Cash PaymentCash PurchasesPayment to creditorsPayment of ExpensesFactory ExpensesAdministrationExpensesPayment of TaxPayment of DividendPurchase of Fixed AssetPurchase of InvestmentTotal(C)Closing Balance(D)=(A+B-C) Depreciation Meaning:- The world ‘Depreciation’ is derived from a Latin word ‘Depressed’ if we analysis this word ‘de’ means decline and ‘pretium’ means price, decline in price or decrease in value of assets whether these may be fixed assets or capital assets. Thus depreciation is the gradual and permanent decrease in value of assets due to wear and tear, effexcion of time, absolves scène or any other case. Definition:- According to R.N carter, “Depreciation is gradual decrease in value of assets due to wear and tear or from any other cause”. According to Pickles, “Depreciation may be defined as the permanent and continues damnation in quality, quantity or value of an asset.” Characteristics of depreciation:- 1) It is reduction in book value of fixed assets.
• 25. calculated. Out of cost of assets its scrap value is deducted and it is divided by number of year of its estimated life. This is the amount of depreciation. Thus, Cost price-Scrap Value Deprecation= Life of Assets Thus the book value of asset will be zero at the expiry of expected life of assets. Example:- If life asset is 10 years, rate of depreciation is 10% of cost every year and cost is Rs. 20,000. Then the depreciation will be Rs. 2000 per annum. If in a first year, the asset may not have been used for whole of year in that case only proportionate amount will be provided as depreciation. Suppose in above case asset is installed on 1 April and account is closed on 31 dec. in that case depreciation for the year will be Rs. 1500 i.e. 20,000 * 10 * 9 100 12 The entry for depreciation is:- 1) For providing depreciation:- (I) Depreciation A/c Dr. To Assets A/c (By name) [For depreciation of the asset] (ii) Profit and loss A/cDr. To Depreciation A/c [For amount of depreciation charged to profit and loss A/c] 2) For sale pf scrap on expiry life:- Cash A/c Dr. To Assets A/c (By name) [For sale of price of scrap realized]Advantages:- 1) This method is very easy. 2) The value of assets can be reduced to zero. 3) Value of depreciation can be easily known.Disadvantages:- 1) In beginning the asset depreciation less and in last years it depreciates more quickly. But under this method amount of depreciation remain same every year. 2) No provision for interest is mode on value of asset. 3) When machine is old enough it’s repairing charge increase. But no attention is paid on this fact under this method. For Example:-
• 26. A purchased a machine for Rs. 11,000 on Jan 1, 1986. The estimated life of machine is 10 years. After which its break up value will be Rs. 1000 only. Find out amount of annual depreciation and propose machinery account for first three years. Solution:- Depreciation= Cost price- Scrap value Life of Assets = 11000-1000 =1000Rs. 10Dr. Cr.Date Particulars Amount Date Particulars Amount1986 To cash 11,000 1986 By Depreciation 1,000Jan 1 A/c Dec.31 A/c 10,000 Dec.31 11,000 11,0001987 To 10,000 1987 By Depreciation 1000Jan 1 Balance Dec 31 A/c 9000 B/d Dec 31 By Balance C/d 10,000 10,0001988 ToJan 1 Balance 9,000 1988 By Depreciation 1000 B/d Dec 31 A/c 8000 Dec 31 By Balance C/d 9,000 9,0001989Jan To 8000 balance B/ d 3) Diminishing Balance Method (or written down value method) Under this method also cost of assets less estimated scrap value has to be written off over its estimated useful life. A certain percentage is calculated on book value and not cost of assets. Thus the amount of depreciations goes on falling every year. The value of asset never comes to zero under this method. Advantage:-
• 27. 1) Under this method there is equal burden of depreciation and repairs on profit loss A/c 2) The book value of assets never falls to zero. 3) This method is recognized by income tax law. 4) This is very simple. 5) It needs no difficult calculation.Disadvantages:- 1) Proper and sufficient depreciation is not provided under this method because rate of depreciation is kept very low. 2) No account is kept of interest on value of assets. 3) Rate of depreciation cannot be easily decided. 4) Fixed Budget:- Acc. To I.C.MA, London,” Fixed budget is, “a budget designed to remain unchanged irrespective of level of activity actually attained.” Thus a budget proposed for a fixed level of activity is known as a fixed budget. It is a fixed budget is one, which is designed for a specific planned output level and is not adjusted to the level of activity attained at the time of comparison between budget and actual cost. A fixed budget can be established only for a small period of time when the actual output is not anticipated to differ much from the budgeted output. However, a fixed budget is liable to revision due to:- 1) Too much dependence of sales upon external factors. 2) Too many seasonal fluctuations. 3) Impossible to pre-judge the customize reaction towards a new return 4) Unpredictability of labour supply.But such revision of becomes a very complicated task. On A/c these limits of fixed budget,flexible budgeting is preformed. These budgets are most suited for fixed expenses but they have only alimited application and in effective as a tool for cost control.Flexible budget:-Acc. To ICMA, London, “a flexible budget is a budget which by recognizing the differencebetween fixed, semi-variable and variable cost is designed to change in relation to the levelof activity attained.” Flexible budget is one which is prepared in such a manner as to facilitatedetermination of budgeted cost for any level of activity. It is also known as “Variable budget” or sliding scale budget”.If a budget is prepared for 70% level of prod. Activity and the actual level of activity levelof activity changes to 80% or 60%; this budget can be easily adjusted to the requestedlevel. Thus budgets are flexible.
• 29. most desirable simply because it is difficult job to prepare precise and accurate estimates of production / sales.Difference between fixed and flexible budget:- Definition Fixed Flexible It known as rigid or It is not rigid inflexible budget. Level of activity It operates on one level It consists of various of activity and less than budgets for different one set of conditions. It level of activity. assumes that these will be no change in the prevailing conditions, which is unrealistic. Analysis of variance Here all cost like F.C, Here analysis of V.C, and S.VC are variance provides related to only level of useful information as activity so variance each cost is analyzed analysis does not give acc. To its behavior. useful information. Cost ascertainment and If the budgeted and F.B. at different level price fixation actual activity levels activity facilitates differ significantly, ascertainment of cost, then the aspects like fixations of S.P and cost ascertainment and tendering of quotations. price fixation do not reveal a correct picture. Basis of comparison Comp of actual It provides a performance with meaningful basis of budgeted target will be comp. Of the A. perf. meaning less especially With the budgeted where there is targets. difference between the 2 activity levels. Ratios:- A) Profitability ratio or B) Activity ratio or turnover ratio or performance C) Financial ratio or solvency ratio D) Miscellaneous ratio or market test ratio.
• 30. A B C D Return on Cop. Turnover Liquidity Earning per share investment Return on share Stock Current liquid Pay out holders Return on fixed W.Cap Solvency Dividend yield assets Gross profit or Total asset Debt-Equity Price earning gross margin N.P ratio Debaters Proprietors Opening ratio Creditors Fixed Assets Debt-service Cap gearing Meaning of BudgetA budget is a detailed plan of operators for some specific future period. It is an estimateprepared is advance of period to which it applies. It acts as a business barometer as it iscomplete programmed of activities of business for the period covered.According to CIMA, London, budget is defined as, “Financial and quantitativestatement, prepared prior to definite period of time, of policy to be pursued duringthat period, for the purpose of attaining a given objectives.”Thus the essentials of budgets are:- (A) It is prepared in advance & is based on future plan of actions. (B) It relates to a future period & is based on objectives to be attained. (C) It is a statement expressed in monetary & physical units prepared for implementation of policy formulated by management.Different types of budgets are prepared by an industrial concern for differentpurposes. A sales budget is prepared for purpose of forecasting sales for futureperiod. A master budget embodies forecasts - for sales & other incomes formanufacturing, marketing & other expenses besides forecasting the figures for profitor loss. Budget V/S ForecastingA forecasting is a statement of facts likely to occur.According to CIMA, London, a forecast is, “a statement of probable events”. Atplanning stage it is necessary to prepare forecast of probable courses of action forbusiness in future. Plans or budget are prepared on the basis of these forecast in orderto achieve objectives of the organization. The forecast of a function need notnecessarily be coordinated which is needed before installation of budget. A forecast istherefore a basis of budget.A budget is a statement of planned events generally expressed in financial &quantitative terms. It is generally evolved from forecast. A forecast denotes somedegree of bossiness while a ‘budget’ denotes a definite target.
• 31. Basis of Budget ForecastDestination(1) Events It relates to planned events i.e. It is concerned with policy & programmers to be probable events likely to followed in a future period under happen under anticipated planned condition. condition during specified period of time.(2) Period It is usually planned separately for It may cover a long period each a/c period. or years.(3) Coverage It comprises whole business unit It may cover limited sectional budgets are coordinated functions of business as into logical whole. sales forecast.(4) Control It is a tool of control as it It does not connote any represents actions which can be serve of control as forecast shaped according to condition is merely a statement of which may or may not happen. future events.(5) Process Process of budget starts where The functions of forecast forecast and converts it into a and with the forecast of budget. likely events.(6) Sphere It is made in respect of those It is made in several other spheres which are related to spheres which may not be business. connected with budgeting process. Purpose of BudgetingThe major purpose important of budgets or budgeting are:-(1) Statement of expectations: A firm establishes long range objectives which arepursued in successive, short run steps in future period of time. A budget is a means toachieve these goals by maintaining relationship between short run goals & long run.Objectives of firm:-It helps to clarify assumptions underlying future goals.For example:- If sales target for next year’s formulated, budget gives detail aboutprices, quantities, sales effort etc. which are based on number of factors such asdemand and supply, technological changes, economic conditions etc.(2) Communication: The people of enterprises should know what goals are, theyshould understand and support them. Top management communicates budget tolower level so as to make them clear what is to be achieved.(3) Planning: It is essential to accomplish goals. It reduces uncertainty andprovides directors to employees by determining course of actions in advance.Budgeting compiles management to plan in a comprehensive way. Planning involveswhat should be done how goals may responsibility and be held accountable.(4) Coordination: To implies proper balance b/w labour, material & otherresources so that goals are attained at min cost. The activities of various departmentsmust remain in harmony with each other. For example, there should be coordinated
• 32. b/w activities of production deptt and sales deptt. It is undesirable to produce aproduct which cannot be profitable sold to sales deptt. Likewise, sales deptt shouldnot create demand for product which cannot be produced by production deptt.(5) Control: It consists of action necessary to ensure that performance of org.conforms to plans and objectives. Control of performance is possible with predetermined standard which are laid down in budget. Thus, budgeting makes controlpossible by continuous comparison of actual performance with that of budget so as toreport variations from budget to mgmt of corrective actions. Essentials of Budgeting:-A successful and sound budgeting system is based upon certain pre requisites whichrepresent mgmt attitude, org structures and managerial approaches necessary for effectiveand efficient application of budgeting system. The following are some imp essentials orfundamental of a successful budgeting. (1) Top management support: A budgeting system will fail is it not installed and supported by top mgmt because it is an important management too. A company will be able to implement budget plans efficiently if top mgmt has positive attitude towards budgeting and gives directions for budget implementations. Budget estimates are generally proposed by line manager but top management has responsibility of coordinating budget of diff departments and approving them finally and initiates follow-up procedure to see that there effective implementation of budgets. (2) Clear and realistic goals: Budgeting is a means to achieve goals and objectives and it cannot succeed if goals are not clear because there will be lack of proper direction, and effort of mgmt will be wasted. Therefore the financial manager must ensure that objectives and goal have been properly laid down, should be written in formal terms, reasonable and realistic. Budget goals should not be set at too high or too low level. Goals set a high level are impossible to attain and employees don’t put any serious efforts to achieve them. Goals set at a very low level don’t provide any challenge to employees and they are less motivated. Goals for an enterprise depend on many factors such as size, age of enterprise, nature of activities and other factors. (3) Assignment of Authority and Responsibility: A sound organizational structure is essential for success of budgetary system. Authorities and responsibilities of each manager should be clearly identified and established which provide an effective means to achieve enterprise objectives in efficient manner. If there is no relationship b/w budgeting system and org structure of enterprise planning and control would not be effective. In the absence of clear – cut assignment of authorities and responsibilities either manager cannot be held accountable for those activities for which they have no responsibilities.
• 33. Creation of Responsibility centers: As the large firm cannot be surprised by an individualor few individuals so for effective control of all activities, each sub unit has certainactivities to perform and its manager is assigned specific authority and responsibilities tocarry out those activities. The sub-unit of an enterprise for purpose of control is calledresponsibility center or decision center. The imp criteria of creating it is that unit of orgshould be separable and identifiable for operating purposes and perform once measurementshould be possible.Advantages of BudgetingBudgeting is the important management tool, it a way of managing. Many benefits arederived from budgeting although it is a mean not an end itself. It is feed forward processthat is it makes an evaluation of variables likely to affect the future operation of enterprises,it predict future with reasonable precision and removes uncertainty to great extent. Thefollowing are some of more signifies advantages of budgeting:1)Forced planning :Budgeting compels the management to plan for future. The budgetingprocess the management look ahead and become the more effective and efficient inadministrating business operation It installs into the managers the habit of evaluatingcarefully their problems and related variable before making any decision.2)Coordinated operation: It helps to coordinate, integrate and balance efforts of variousdepartments in light of overall objectives of enterprises. This result in good harmonyamong departments.3)Performance evaluation and control :Budgeting facilitates control by fixing standardsand then compare the standard with actuals to evaluate performance. If any deviationoccurs measurable steps are taken.4)Effective communication :It improves quality of communication The enterprisesobjectives budget goals ,plans, authority and responsibility and procedures to implementplans are clearly written and communicated Through budgets to all individuals in theenterprises. This results in the better understanding and a good relations among managersand subordinates.5)Optimum utilizations of resources: It help to make the optimum utilization of theresources that is capital and human by directing their effort in most profitable channels.6)Productivity improvement: It increases morale and thus the productivity of employeesby seeking their participation in the formulation of plans and policies bringing harmonybetween individual goal and the enterprises objective by providing incentives to performmore effectively.7)Profit mindedness: Budgeting develops the atmosphere of profit mindedness and thecost conciouness .It helps in preventing waste, reducing expences and attaining desiredreturn on investments.8)Management by exception: Management give the attention on important mattersthrough budgeting reports and facilitates the management by exception and thereby savestime and energy
• 34. 9)Efficiency: It measures efficiency ,permits self evaluation and indicates progress inattaining enterprises objectives.Limitations in budgeting1)Budget plan is based on estimates: Budgeting is not an exact science and it based onfacts and managerial judgement which suffers from personal biases. The success or failureof budget depends to a large extent upon accuracy of basic estimates or forecasts.2)Continous adaptation :Budgeting is the dynamic process The installation of perfectsystem of budgeting is not possible in the short period .Business conditions change rapidlytherefore budgeting programme should be continuously adapted. and should be continousprocess .Management should not loose patience and go on trying various technique andprocedure in developing and using budgeting system to achieve the success.3)Implementation: Unless budget is properly implemented ,budget programme will notwork. For success of budgeting programe it is essential that it is understood by all and allperson s in the enterprises must have full involvement in preparation and execution ofbudgets, otherwise budgeting will not be effective.4)Management complacency: Budgeting is a management tool- a way of managing andnot the management .To get the best result of managing ,management should use budgetingwith intelligence and foresight along with the other managerial techniques.5)Unnecessary details: Budgeting will be ineffective and expensive if it is unnecessarilydetailed and complicated A budget should be precise format and simple to understand andshould be flexible.6)Good conflict: If budget set does not matches with the purpose of budgeting ofenterprises then there will be conflict and confuses so there must be harmony withenterprises aims.7)Evaluation: Budgeting will hide inefficiencies instead of reveling them if a propersystem evaluation lacks. There should be continous evaluation of actual performance andstandards should be re- examined regularly.8)Unrealistic targets: Budget will lower morale and productivity if unrealistic targets areset and if it is used as pressure tactic72 – 77Stages in Installing Profit Panning and Control System: -A comprehensive system of profit planning and control involves the following steps:A formulation and clear statement of broad, long-range objective of the enterprise;Determination of the goals of the various departments or sub-unit, and their role andsignificance in the accomplishment of broad, long-range objective. This includes
• 37. in cash and vice-versa. A company’s cash balance can decrease when its net income is high, and cash can increase when income is low. The users want to know the difference between the net profit and net cash provided by operations. The net profit shows the progress of the business during the year while cash flow related more to the liquidity of the business. The users can assess the reliability of net profit with the help of cash flow statement. 4) Efficiency in cash management: - Cash flow analysis helps in evaluating financial policies and cash position. It facilities the management to plan and co-ordinate the financial operations properly. The management can estimate how much funds are needed, from which source they will be derived, how much can be generated internally and how much should be arranged from outside. 5) Discloses the movement cash: - A comparison of cash flow statement for the previous year with the budget for that year would indicate to what extent the resources of the enterprise were raised and applied. A comparison of the original forecast with actual result may highlight trend of movement that might otherwise undetected. Distinction between funds flow and cash flow statements:- a) Funds flow statement is consonant with the accrual basis of accounting while in case flow statement; data obtained on accrual basis are converted into cash basis. b) Funds flow analysis is more relevant and useful in assessing the long range financial strategy, while cash flow analysis is useful in understanding the short term phenomena affecting liquidity of the business. c) Funds flow statement tallies the funds generated from various sauces with various uses to which they are put. Cash-flow statements show the cash flows form operating, financing and investment is adjusted to the opening balance of cash and cash equivalent to arrive at the closing balance. d) Funds flow analyses is based on a broader concept that is working capital, while cash-flow analysis proceeds on the narrow concept that is cash, which is one element of working capital. Thus, cash flow statement provides details of cash movements where as the funds flow statement provides the details of funds movement. e) Funds flow statement does not contain any opening and closing balance whereas in cash flow statement opening as well as closing balance of cash and cash equivalents is given. Cash flow statement:- Where it is derived to explain to management the source of cash and its uses during period of time a statement known as cash flow statement is prepared. A statement of cash flow report inflows (receipts) and outflows (payment) of cash and its equivalents of an organization during a particular period. A statement of cash flow report cash receipts and payment classified according to major activates-operations, investing and financial during the period. 94- till endManagement by exception: The principle “management by exception” can be madeapplicable in the business. This helps the mgmt in concentrating its attention on cases
• 38. which are off standard i.e. below or above the standard set in the trend of cost is portrayedand therefore, a pattern is provided for the elimination of undesirable factors causingdamage to the business.Better economy efficiency, productivity: Managerial review of costs is more effective asthe operations are scrutinized carefully and in efficiencies are disclosed. Men, machinesand materials are more effectively utilized and thus the economics can be affected inbusiness together with based productivity. Besides it, a lot of clerical lab our is also savedand economy is attained in calculation and computations.Limitation of SCStandard costing is a powerful mgmt aid in planning, control, & decision-making. But if itis improperly handled & if due consideration is not given to various constraints indeveloping and using standards, it can create problems for mgmt. The following are thelimitation-->Difficulty in setting standards  it is difficult to forecast cost as some of factorsinfluencing them are unpredictable. Secondly, standards are set by human beings, whoseprejudices and biases are likely to influence the establishment of standards.Inflexibility of standards: Standards have the tendency of becoming inflexible or rigidovertime. Standard set at a point of time are based on assumptions of operating conditionswhich may change frequently and its diff to revise standard conditions change. Thefrequent revision of standard is diff as well as expensive. If standards are revised frequentlythey will mar the performance and efficiently evaluation criterion. On other hand ifstandards are not revised for changes in operating cycle, they would become unrealistic.Therefore in real practice standards should be revised for every change operatingconditions, but they should be certainly adjusted if the change is significant.Problems in Variance Analysis :-> Standard costing helps in managerial control throughvariance analysis. It is difficult to explain variance when need arises to distinguish betweencontrollable & non-controllable elements of variances. More over, if a variance is causedby random factors, it becomes more difficult to explain the variance.Discouraging Impact of Standards :-> Standards are sometimes considered to havediscouraging impact on efficiency & morale of individuals. Some of recent studies revealthat workers & supervisors do not welcome standards because they consider them to beoppressive & resist them.Unsuitable for Small Firms :-> In small org., Production operations are simple & thereforedetailed analysis may not be necessary.Failure due to Top Management Apathy :-> For success, top management should not onlytake keen interest in it but should also seek participation of all. At times, it becomesdifficult to seek real support of top management. They may not disagree to idea ofintroducing standard cost system but at same time may not take interest in its effectiveimplementations. Standard costing v/s budgetary control
• 39. Both standard costing and budgetary control achieve the same objective of minimumefficiency and cost reductions by establishing predetermined standards, comparing actualperformance with predetermined standards and taking corrective measures wherenecessary. Thus, although both are useful tools to the mgmt in controlling costs, they differin following respects: -Point of Distinction Standard costing Budgetary control(1) Basis Standards are based on technical Budgets are based on past assessment assessment(2) Application It is applied to manufacture of a It deals with operations of a product, process or services. Thus department of business as a whole. it is intensive in application. It is extensive.(3) Scope Standards are set mainly for Budgets are compiled for all items production and production of income and expend fore. expends. Therefore it has narrow Therefore, it has wider scope. scope(4) Limit of Standards setup targets, which are Budgets setup max limits ofexpenses to be attained by actual expenses above which actual performance. expenditure should not normally exceed.(5) Projection Standards are Budgets are projections of financial Projections of cost account because accounts. Because financial cost accounting deals with accounting deals with overall individual products, ascertaining efficiency of the business such as and controlling their costs. And sales functions, purchase functions, standard costs aim at efficiency at production functions etc. every point.(6) Variance In standard costing, variance is In this technique, variances are not analyzed in detail according to revealed through accounts but are their originating causes. Thus, revealed in total Standard costing reveals variances through different accounts.(7) Forecasting Standard costs do not tell what the Budgets are anticipated or expected costs are expected to be but rather costs meant to be used for what the cost should be under forecasting requirements of material specific conditions of production , lab our , cash etc. performance and as such cannot be used for the purpose of forecastingFixed budget v/s Flexible budgetPoint of Distinction Fixed budget Flexible budget(1) Flexibility It is flexible and does not change It is flexible and can be suitably with the actual volume of o/p recanted quickly according to level achieved. of activity attained. It is designed to change according to changed conditions costs are classified according to the nature of their variability.
• 40. (2) Condition It assumes that conditions would It is designed to change to change remain static. according to changed conditions.(3) Classification of Costs are not classified according Costs are classified according to thecosts to their variability i.e. fixed nature of their variability. variable and semi-variable.(4) Comparison Comparison of actual and budgeted Comparisons are realistic as the performance cannot be done changed plan figures are placed correctly if the volume of o/p against actual ones. differs(5) Forecasting It is difficult to forecast accurately It clearly shows impact of various the results in it. expenses on the operational aspect of the business.(6) Budget Only one budget at a fixed level of Under it, series of budgets are activity is prepared due to an prepared at different levels of unrealistic expectation on the part activity. of mgmt i.e. all condition will remain unaltered.(7) Ascertainment of It is possible to ascertain costs Costs can be easily ascertained atcosts correctly if there is a change in different levels of activity under this circumstances. type of budget.(8) Tool for costs It has a limited application and is It has more applications and be usedcontrol ineffective as a tool for cost as a tool for effective cost control. control.(9) Fixation of price If the budgeted and actual activity It helps in fixations of price andand sub mission of levels vary, the correct submission of tenders due to correcttenders. ascertainment of costs and fixation ascertainment of costs. of prices becomes difficult.Cost accounting v/s financial accountingPoint of distinctions Financial Accounting Cost Accounting(1) Purpose It provides information about the It provides information to mgmt for business in general way. It tells proper planning, operation, control about and decision-making.(2) Form of account These accounts are kept in such a These accounts are generally kept way as to meet the requirement of voluntarily to meet requirement of companies’ act and income tax act. mgmt. But now companies act has made it obligatory to keep cost records in some manufacturing industries.(3) Recording It classified records and analysis It records the expenditure in an the transaction in subjective objective manner. I.e. according to manner i.e. according to nature of the purpose for which the costs are expanses. included.(4) Control It lays emphasis on the recording It provides detailed system of aspect without attaching any control for material, labor and importance to control overhead costs with the help of standard costing and budgetary control
• 41. (5) Periodicity of It reports operating results and It gives information through costreporting financial position at end of year. reports to mgmt as and when desired.(6) Analysis of profit Financial accounts are accounts of It is only a part of financial account whole business. They are and discloses profit or loss of each independent in nature and disclose product, job, and service. net profit or loss of business as a whole.(7) Information It uses only monetary information It uses both monetary and non monetary information(8) Figures It deals mainly with actual figures It deals partly with facts and figures and facts and partly with estimates.(9) Stock valuation Stock are valued at cost or market Stocks are valued at cost. price which over is less Break Even AnalysisIt is a widely used technique to study the cost -volume –profit relationship. The narrowerinterpretation of term break –even analysis refers to system of determination of that level ofactivity where total cost equals total selling price. The broader interpretation refers to thatsystem of analysis which determines probable profit at any level of activity. It portrays therelationship between the cost of production, volume of production and sales value.Break –even analysis indicates the level of sales at which cost and revenue are inequilibrium .The equilibrium point is commonly known as break even point, The breakeven point is that point of sales volume at which total revenue is equal to total cost.Utility of Break Even Analysis:It is the most useful technique of profit planning and control. It is a device to explain therelationship between the cost volume profit .The utility of break even analysis lies in thefollowing advantages:1) Provided detailed and understandable information:Break even analysis is a simple concept to present and interpret accounting data. Manybusiness executives and other are unable to understand accounting data contained in thefinancial statements and reports but break even charts visualizes information very clearlyand a look at a glance shall give a vivid picture of whole affairs. The different elements ofcost direct material, direct labour, overheads (factory, office and selling etc) can bepresented through an analytical break even chart. Further the information is in a simpleformat therefore it is clearly understandable even to layman.2) Profitability of product and business can be known:The profitability of different can be known with the help of break even chart, besides thelevel no profit no loss .The problem of managerial decision regarding temporary orpermanent shutdown of business or continuation at a loss can be solved by break evenanalysis .It is thus provides the basis information for profit improvement studies and it isuseful starting point for the detailed investigation.
• 42. 3) Effects of changing of cost and sales price can be demonstrated:The effect of changes of fixed and variable cost at different level of production on profitscan be demonstrated by graph legibly. In other words relationship of cost, volume, profit atdifferent level of activity and varying selling prices is shown through chart. Thus it studiedrequisites for survival of the company.4) Cost control can be analyzed: The relative importance of fixed in the total cost of product can be analyzed and if the totalcost are high, they can be controlled by the management. Thus it is a managerial tool forcontrol and reduction of cost, elimination of wastages and achieving better efficiency.5) Economy and efficiency can be affected:The capacity can be utilized to fullest possible extent and economies of scale and capacityutilization can be affected. Comparative plant efficiency can be studied on break evenchart. The efficiency of output is indicated by the angle of incidence formed at intersectionof sales line and the variable cost.6) Diagnostic tool:It is useful diagnostic tool. It indicates to management the cause of increasing break evenpoint and falling profit the analysis of these causes will reveal that what action should betaken. If break even point as a percentage of capacity is increasing, it indicates theunfavorable condition and need immediate action .It is possible that due to plant expansionabsolute break even point may increase. This situation where break even point as apercentage of capacity may does not increase, is not unfavorable.Limitation of break even analysisThough break even analysis is a simple and useful concept but it is based on the certainassumption which limits its utility and general applicability. However it suffers from thefollowing limitations:1) Based on the false assumptions:A) Cost segregation: It is difficult to classified fixed and variable cost. However some of the can be easilyidentified as fixed such as rent of building, or variable such as direct material cost but alarge number of cost belong to mixed category .such cost known as semi-variable costconsists of fixed as well as variable cost and are difficult to separate. B) Fixed cost remains constant:The assumption that fixed costs remain constant does not hold good. If a firm has zerooutput some of fixed cost can certainly be reduced or eliminated. For example some of thesupervisors can be dismissed and the salaries can be reduced. On the other hand if thecompany uses its ideal capacity additional fixed cost may be incurred. Thus fixed costs arenot constant and can change in the stepwise fashion.
• 43. C) Variable cost very proportionately:The variable cost does not change in the same proportion as volume of production or saleschanges. for example if the company increases its production or sales it need more workerswho may be less efficient and less experienced or existing workers need overtime andcompany have to pay for it. Similarly material cost will be less due to purchase, discounts,if purchases in bulk. So lines drawn are not straight and sometimes a curved line isobtained in respect of total cost.d) Change in selling price:Similarly selling price may remain the constant under the perfect competition. But in thereal market situation of monopolistic completion or oligopoly selling price have to bereduced to increase the sales volume. Thus sales revenue will not change in the directproportion with output.e) Stock changes do not affect incomes:The break even chart depicts volume of production or sales along x axis and thus ignoresthe effect of changes in stock volume. As a matter of fact it is assumed that stock changeswill not affect income, but it is not true since the absorption of fixed cost depends on theproduction and not on sales.2) Limited information: can be presented in a single break even chart. If we have to studychanges of fixed cost, variable cost and selling prices, a number of charts will have to bedrawn up Similarly when a number of products are manufactured it would a difficult task topresent information through single break even chart.3)Short term focus: It is a short term technique of profit planning and can not be used forthe long term planning because it lead to long term decision. For example a companywishes to increase his productive capacity and it may not yield enough revenue in the firstyear. Thus in the term of break even analysis company may drop idea of adding toproductive capacity, but it may be beneficial over a long period of time.4) NO necessity: There is no necessity of preparing the break even charts on account of thefollowing reasons:A) Simple tabulation sufficient: because result of cost and sales can serve the purposewhich is served by break even chart. Hence the need of presentation through chart andusing mathematical tool of break even analysis does not arise.b) Conclusive guidance not provided: No conclusive basis for action is provided tomanagement by technique of breakeven analysis,c) Difficult to understand: The chart becomes very complicated and difficult tounderstand particularly for the non technical man, if number of lines or curves depicted ongraph is larged) No basis for comparative efficiency:Charts do not provide any basis for the comparative efficiency between the different units.In spite of all above limitation it remain an important tool for the profit planning what isneeded is that financial analyst should understand underlying assumption and theircorresponding limitation and adjust his data appropriately to suits his needs.
• 44. Marginal costingMeaning: According to CIMA terminology Marginal costing is ascertainment of marginalcost and of the effect on the profit of changes in volume or the type of output bydifferentiating between the fixed and the variable cost. In this technique only variable costare changed to operation, processes or products, leaving all the indirect cost to be writtenoff against profits in period in which they arise. It is clear from above that only variable cost form part of product in thetechnique of marginal costing because only variable cost are changed if output is increasedor decreased and fixed cost remain the same. With the increase of one unit of production may be single or batch of article’sthe total cost of production increased and this increase in the total cost of production fromexisting level to new level if known as marginal cost.This will be clear from the following example: A factory produces 500 fans per annum.The variable cost per fan is Rs 50 .fixed expenses are Rs 10000per annum. Thus the costsheet of 500 fans will be as follows: Variable cost (500 *50) 25000Fixed cost 10000Total cost 35000If the production is increased by one unit i.e. it becomes 501 fans per annum, Cost sheetwill appear as follows:Variable cost (510*50) 25050Fixed cost 10000Total cost 35050Therefore marginal cost per unit is Rs 50Formula:Marginal cost= direct material +direct labour cost+ other variable costFeatures of Marginal costing:1) It is a technique of costing which is used to ascertain marginal cost and to know theimpact of variable cost on the volume of output.2) All cost is classified into fixed and variable cost on the basis of variability .Even semi-fixed cost is segregated into fixed and variable cost.3) Variable cost alone are changed to production .fixed cost are recovered fromcontribution.4) Valuation of stock of work in progress and finished goods is done on the basis ofmarginal cost.5) Selling price is based on the marginal cost plus contribution.
• 45. 6) Profit is calculated by deducting the marginal cost and fixed cost from the sales.7) Cost volume profit (break even) analysis is one of the integral parts of the marginalcosting.8) The profitability of product is based on the contribution made available by each product.Marginal costing vs. Absorption costingMeaning of Marginal costingMeaning of Absorption costing: Absorption costing is a technique of ascertaining cost. Inthis technique both variable and fixed cost are charged to product, operation pr process. Itis also “full operation costing technique”Following are the points of difference between the absorption costing and marginal costing:Basis Absorption marginal1) Cost all costs fixed and variable only variable cost are included. Are included for ascertain- fixed cost are removed from Ing the cost. Contribution. Thus marginal cost= Absorption cost=fixed+ total cost- (-) fixed cost Variable cost2) Different unit cost are marginal cost per unit willremain Obtained at different level same at different level of output Of output because of because variable expenses vary in Fixed expenses remaining same proportion in which output Same. Varies3) Profit difference between sales difference between sales and And total cost is profit. Marginal cost is contribution And difference between contributions And fixed cost is profit or loss.4) Absorption of the apportionment of fix- only variable cost are charged to Overheads ed expenses on an arbiter- products. Marginal cost technique ary basis gives rises to do not lead to over and under Over or under absorption absorption of fixed overheads. Of overheads which Ultimately makes product Cost inaccurate and unreal -iable.5) Decisions it is not very helpful in the technique of marginal costing Taking managerial is very helpful in taking managerial Decisions such as whether decisions because it takes into To accept export order or consideration the additional cost Not, whether to buy or involved only assuming fixed Manufacture. Minimum expenses remain constant. Price to be charged during Depression etc.6) Classification cost are classified according cost are classified according To functional basis such as to behaviour of cost i.e. fixed
• 46. Production cost, office or and variable cost. administrative cost and selling and distribution cost.7) Relationship It fails to establish relation cost –volume -profit ship of cost, volume and relationship is an integral profit as cost are seldom , part of marginal cost classified into fixed and studies as cost are classified variable. Into fixed and variable costs.Advantages of Marginal costing:With the help of marginal costing technique managerial decisions can be taken regardingthe several matters are discussed as under:1)How much to produce: The level of output which is most profitable for a runningconcern can be determined. Therefore production capacity can be utilized to the maximumpossible extent. Ascertainment of most profitable relationship between cost, price and volume ofbusiness shall also assist management in fixing the best selling prices. Thus maximisationof profit can be achieved and profit planning becomes easier on the basis of applyingmarginal costing technique2)What to produce: The manufacture of which product should be undertaken can bedecided upon after comparing profitability results of different products. Certain products oractivities may turn to be unprofitable with the passage of time. When existing capacity is to be utilized for producing the different product invarying quantities marginal costing is the good guide for deciding the optimumcombination of products to match the available capacity and resources. Thus for the choiceof alternative products and introduction of new products marginal costing technique ishelpful to a great extent.3)Whether to produce: The decision whether a particular product should bemanufactured in factory or bought from outside sources can be taken at comparing prices atwhich it can from outside and marginal cost of producing that article in the factory.4)How to produce.a)Method of manufacture: When a particular product can be manufactured by two ormore methods the ascertainment of marginal cost of manufacturing product under eachmethod shall be helpful in deciding as to which method should be adopted for itsmanufacture.b)Hand or machine labour: The problem of employing machine or to produce entirely byhand labour can be solved with the help of marginal costing technique.5)When to produce: In periods of trade recession whether the production
• 47. on the plant is to be suspended temporarily or permanently closed down can be decidedupon after carefully examining marginal cost structure.6)At what cost to produce a)Efficiency and economy of plants :The marginal cost indicates efficiency and economyof different plants over different ranges of products volume and outputb)No profit no loss point: With the help of technique of break even charts involved underthe marginal costing system point of no profit on loss can be raveled and information canbe presented to the management so as to facilitate the comparisons.c)Lease or ownership of plant: The cost of lease and ownership are studied and betteralternative is adopted after judging and assessing the minimum sacrifice and maximumdifferential gain through technique of marginal costing.d)Cost control: cost control can be effected through comparing fixed and variableelements of cost with the budgeted costs.e)Inventory valuation: Becomes the more realistic when it is based on the marginal cost.Fruitful results can be derived by combining this technique with the standard costing andbudgetary control technique . T Thus we can see technique of marginal costing is of immense value for managerialdecisions.Limitations of marginal costing:1)Classifications into fixed into variable elements a difficult task It is tough job toanalysis cost under the fixed and variable elements since the nature of the cost is not certainin some cases. Certain cost may be partly fixed and partly variable and the division of suchcost into fixed and variable parts separately is based in the assumptions and not facts.Certain overheads have no relations to volume of output or even with the time thus theycannot be categorised either fixed or variable .Management decisions regarding bonus toworkers ,facilities to administrative staff etc. are taken without an consideration of time orproduction volume.2)Faulty decisions :If the fixed overheads are not taken into consideration managementdecision regarding the price fixing manufacturing the product etc. may prove to be faultyand deceptive. Marginal costs of the different products may be same, still manufacture of aparticular product may not be profitable on account of heavy fixed costs.3)Difficult application: The application of marginal costing technique is difficult in mostconcerns. It cannot be easily applied in the job costing.4)Under or over recovery of overheads: As variable overheads are estimated and notbased on the actual, there under and over recovery of overheads may results.5)Better technique available: The system of budgetary control and the standard costingserve the purpose better than the marginal costing system. Through variance analysisimpact on the profitability due to changes in the volume and the efficiency can be studiedand hence this technique is not required.
• 48. Application of Marginal costing:Marginal costing is a very useful tool for the management because of its followingapplications:1)Cost control :Marginal costing divides the total cost into fixed and variable cost andbring out the reason as to why profits are decreasing in spite of increasing in sales.Moreover in marginal costing fixed cost are not eliminated at all. These are shownseparately as deduction from contribution instead of merging with cost of sales. This helpsmanagement to control fixed cost in long period as these cost are programmed in advance.2)Profit planning: ie planning for the future operation in such a way as to maximize theprofit .Absorption costing fails to bring out the correct effect of change in sales price,variable cost or product mix on profit of concern but that is possible with the marginalcosting.3)Evaluation of performance:It is useful for evaluating performance of each sector ofconcern by making difference fixed and variable expenses. A product or the departmentwill give the higher contribution should be performed if the fixed expenses remain thesame.4)Decision makinga)Fixation of selling price :Marginal cost of product represents minimum price for thatproduct and any sale below the marginal cost would lead to loss .The price of productshould be fixed at a level which not only covers the marginal cost but also make thereasonable contribution to cover the fixed overheads.b)Maintaining a desired level of profit: The industry has to cut its price of product fromtime to time on account of competition, government regulations and other reasons. So thecontribution per unit is reduced while industry is interested in maintaining the minimumlevel of its profit. So the volume of sales at which company earned desired level of profitcan be determined through the marginal costing.c)Selection of suitable product mix: When the factory manufactures more than oneproduct, a problem is faced by the management as to which product mix will give themaximum profit. The best product mix is that which yield maximum contribution and theproduction of that product should be increased .The product which give the lesscontribution should be reduced or closed down. The effect f sales mix can be seen bycomparing p/v ratio and break even point.d)Make or buy decision :Whether a particular part of finished product is to bemanufactured within the industry or it has to be brought from outside will depend on theconsideration of marginal cost. Marginal cost of manufacturing is to be compared withpurchase price of relevant material and if the cost is more than the purchase price adecision is to buy product from market .However certain non cost factors must beconsidered:1)In favour of making:a)Ideal facility available
• 49. b)Quality of market supplyc)Desirability of maintaining certain facilities2)In favour of buyinga)Lack of capacity requiredb)Wider selection etc.e)Alternate method of production :Marginal costing is helpful in comparing thealternative method of production ie machine work or hand work . The method gives thegreatest contribution(assuming fixed cost remain the same)is to be adopted where howeverfixed expenses change the decision will be taken on the basis of profit planning.f)Exploring the new markets: Decision regarding selling goods in the new markets(whether Indian or Foreign)should be taken after considering following factors:1)Whether firm has surplus capacity to meet new demand?.2)What price is being offered by new market?3)Whether sale of goods in new market will affect present market for goods?g)Shut down or continue: While deciding whether to shut down not a comparison hasbeen made between1 cost-e.g loss of goodwill ,compensation to workers, packing andstoring cost of plant 2 benefits-e.g saving of fixed cost etc. on account of shut down .Incase benefits exceed the cost it is advisable to shut down or vice- versa.Rules for preparing the Trial BalanceWhen balance of accounts are given and it is asked to prepare the trial balance from thesebalance, we should follow following rules:1)All expenses and losses are debit balances:As all the expenses and losses are debit balances they are shown on the debit side egpurchases, wages, import and export duties, postage and telegram expences ,discountallowed , salaries ,return inwards and interest paid ,electricity ,stationary, telephoneexpenses insurance office expenses repairs etc.2)All income and gain are credit balances: As all income and gain are credit balancesthey are shown on the credit side e.g sales, purchase return ,interest received and discountsreceived ,interest on investments etc.3)All assets drawing and reserve on liabilities are debit balances. All these are shown in thedebit balance of the trial balance. e.g furniture bills receivable, plant and machinery cash inhand ,cash at bank ,prepaid expenses, goodwill etc.4)Capital ,reserve on assets created out of profit and other liabilities are credit balances andshown on the credit side of the trial balance e.g loan ,bill payable ,outstanding expenses,reserve for bad debts, discount on debtors ,general reserve fund ,provident fund etc.5)Opening stock is the debit balance